If there are two pieces of apparently contradictory advice that dominate any discussion of personal finance, it is the need to save for retirement and the importance of eliminating credit card debt. Why do they seem contradictory? Because they can be difficult to prioritize. You need to save money so you have funds for retirement. But eliminating debt also improves your retirement prospects, not to mention gives you a better quality of life now.
The real question is, how do you balance these two critical imperatives?
Why Debt in Retirement Is So Bad
Being obligation-free is rarely a bad thing. But why is debt elimination so important in connection with retirement?
It really reduces expenses
Lowering living expenses is a critical aspect of retirement planning; You won’t be earning as much, so you’ll need to live on less. A $1,200 mortgage payment, a $400 car payment and a $200 monthly credit card payment are major non-discretionary expenses. Paying them off will have a far greater impact on your cash flow than clipping coupons, taking “staycations,” or taking advantage of the early bird special at your favorite restaurant when retirement comes around.
Cash flow is greater on a paid debt than on an investment
Many people are now carrying a mortgage into retirement despite being able to pay off the balance. That can be a strategic mistake: $100,000 invested in a certificate of deposit paying 2% won’t generate as much income as the same amount outstanding on a 5% mortgage will consume in expenses. You’ll lose money for as long as the arrangement exists. You might use stock market returns to support the idea of keeping a mortgage outstanding (“why should I pay off a 5% mortgage when I can get 8% in mutual funds?”), but this is faulty reasoning. That 5% mortgage is a guaranteed expense, but the 8% return in stocks is not. A big hit to the stock market could wipe out a big chunk of your investment capital, while your mortgage balance due remains the same.
As income falls, so do tax deductions
One of the common benefits of owning a home with a mortgage is the tax benefit that comes from being able to deduct mortgage interest for income tax purposes. But the tax benefits of having a mortgage on your home when you were fully employed and in the 35% marginal tax bracket won’t be as sweet when you’re retired, making less money and paying income tax at a rate of 15% on the high end.
Peace of mind
Close your eyes for a second and think about retirement—a sense of peace is somewhere in the mix, isn’t it? Now close your eyes for another second and think about debt—is peace in there anywhere? Unless you enjoy discomfort, probably not.
One of the overlooked aspects of retirement planning is being intentional about eliminating stress from your life. Debt is a common source of stress for most people, fully qualifying it for elimination. You need and should want to get rid of anything that will slow you down, impair your existence or restrict your options. Debt can do all three.
Are Any Kinds of Debt Worth Keeping?
In a word, No! There is no such thing as “good debt” when you’re retired. We’ve already considered the implications of carrying a mortgage—the ultimate “good debt”—into retirement, but let’s consider another debt favorite: the car loan.
Many people have become accustomed to carrying one and, on some level, that makes sense. A car is, after all, a long-term asset and “expensing it” over several years with a loan seems almost natural, even if you’re retired. But look what it does to your cash flow. Using round numbers, let’s say you have a car loan with a modest (by today’s standards) payment of $375 per month; that’s $4,500 per year. Now let’s also say that you have two cars, one for you and for your spouse—and they have matching loans against them. Now we’re talking $750 per month, or $9,000 per year.
How much investment capital do you need to have to cover that kind of expense? If we’re charitable and say that you can reliably expect to earn 6% on your investments, you’ll need to have $150,000 invested to cover your $9,000 annual car loan bill. Can you afford that?
That could be a huge chunk of your portfolio, all to pay for an asset that is constantly depreciating. The same is true of credit card debt, and nearly any other loan type you can think of.
Why Credit Card Debt Is Especially Lethal
We’ve said there’s no such thing as good debt. But some forms of debt are worse than others. And credit card debt ranks only slightly better than payday loans. Unlike a home mortgage or a car loan, credit card debt is unsecured debt and, as such, is subject to much higher interest rates, with APRs reaching into high double digits.
Interest paid on education loans and on the mortgage on your primary residence is usually tax deductible, but credit card interest only profits the bank. At the same time, most people with credit card debt continue to use their card to pay for day-to-day expenses.
With most cards, when you carry even a small balance you forfeit your grace period on all purchases and you end up paying interest on all charges from the moment of the transaction. Credit card debt cripples you financially until it is paid off. A $20,000 credit card balance at a 20% interest rate will take 84 years to pay off, if you make only the $400 monthly minimum payment.
Retirement Savings: Save or Lose the Opportunity Forever
There are plenty of important expenses that can be deferred. You can get along with the same old car for one more year, or just repair the septic tank line instead of replacing it with a whole new system. Unfortunately, retirement savings is not a good candidate for deferral.
Due to the nature of compounding interest, and the annual legal limits to contributions, you cannot easily replace your savings this year by making a larger investment next year. Money saved this year is inherently more valuable than the same amount put away next year. With each passing year, the money you saved becomes even move valuable. And every year you put off saving for retirement is a year lost to investment and to reaping the benefits of compounded interest. You’re cutting off time on both ends—the ability to contribute and how many years left to retirement.
Credit Card Debt or Retirement Savings?
With so much stacked again credit card debt, it would be easy to encourage people to pay it all off before they contribute to their retirement savings. In a perfectly logical and rational world that might be good advice, but we don’t live there.
Despite everything that is wrong with carrying a balance, the majority of credit card holders in this country continue to do so. In light of the widespread persistence of credit card debt, it would be irresponsible to advise anyone put off retirement savings until all their debt is paid off. This is especially true when you consider that revolving credit card debt is, unfortunately, often a lifetime habit.
Another factor to consider is any employer match you can receive by contributing to your 401(k) or other retirement plan. Although it might slow your credit card repayment plan down, setting a little bit of money aside today to receive your employer’s match may make financial sense.
It really depends on how bad of a debt situation you find yourself in. If a few dedicated months of focus could wipe out those outstanding balances, it might make sense to turn off your 401(k) contributions for a while to get rid of that pesky plastic debt completely. So let’s look at how to do that.
Get Out of Credit Card Debt
If you just hope to get out of debt, it likely will not happen. You must take concrete steps to incrementally climb out of the hole you’ve dug for yourself.
- Organize your bills. Sit down with all your “set” bills such as rent/mortgage, car payment, student loans, utilities and the rest. Figure out how much you pay for these fixed, nondiscretionary costs. Take your last two pay stubs and calculate how much of your monthly income you need to set aside to pay your monthly “set” bills. If you are paid more often than bi-weekly, grab your stubs for a month’s worth if income. Now, collect all your credit card bills, organize them from the highest interest-bearing account to the lowest. Calculate the minimum payment you need to make on every card. By law, your monthly bill should clearly state how long it will take to pay off the debt with that minimum payment.
- Do the math. Take what is left from your monthly income after your set bills are accounted for, and subtract the total you need to make your minimum payments on your credit cards. Whatever is left over from that, is what you will apply toward the balance on the credit card with the highest interest rate. If your income does not cover your payments, you have a problem: You must either cut expenses or increase your income.
- Avoid minimum payments. Once you have gotten yourself organized, see what you can do about paying more than the minimum payments. The minimum payments are designed to keep consumers paying for years and years, which translates into thousands of dollars of profit for the credit card companies. If you follow the steps outlined above, you will be paying a great deal more than the minimum amount on your highest interest-bearing credit card, which means that you will be able to pay off this card faster. Once that card is paid off, stick it in a drawer so you don’t use it and put all the money you were paying on the bill toward the card with the next highest APR.
- Stop spending. When you make the decision to pay off your credit card debt, you also have to make the decision to stop using those cards. Put a set amount of cash aside to use for your expenses such as gas and food, and use the cash to pay for them rather than swiping your plastic. Paying extra on top of your minimum payment does you no good if your credit card balance keeps climbing. A great way to avoid using your cards is to leave them at home. If you don’t have a credit card with you, even if you are tempted to splurge on that great pair of shoes or another drink, you won’t be able to afford it. (Don’t close out the cards because that will affect your credit utilization ratio, a key element in your credit rating.)
- Commit to the plan. Create a “Payoff Chart” and budget how much you will have to pay to each card every month, where your balance will stand at the end of each month and what month each credit card will be paid off. You can slowly start to build psychological momentum as you see where the first card is paid off, and how much faster the second card will be paid off, and so on. You could also tie in small rewards for each time you “beat” a card, like putting a small deposit into a savings account or Roth IRA.
The Bottom Line
Debt and retirement are not compatible; either debt is eliminated or retirement is compromised. Clearing the deck of anything that looks like a debt will be a major step forward in your retirement planning. And indeed, that’s the way to think of it: Reducing debt, especially credit card debt, is part of saving for retirement.
Our contradictory imperatives aren’t really contradictory—they’re two sides of the same coin. While you’re living, working and consuming on your way to retirement, be sure to carve out a place for reducing those outstanding balances in preparation for the day when you cash out on your career.