One of the most common nuggets of advice dispensed by financial experts is to pay down your debt aggressively. According to this strategy, paying down high-interest rate loans and debt before saving for retirement ensures that compound interest doesn’t eat up any more of your disposable funds than is necessary.
In many personal financial situations, this makes sense. However, the recession of 2008 and the ongoing economic uncertainty changes the game for many Americans who are carrying debt today. There are several sets of circumstances that make paying down debt a dangerous (and sometimes, costly) strategy.
Paying down non-revolving debt does not result in having access to additional credit. For example, making a mortgage payment doesn’t give you automatic room to borrow additional funds. Paying down a credit card, on the other hand, allows you to borrow back up to the card limit again.
Since the 2008 recession, however, card issuers have been locking down a significant amount of credit card limits, meaning that, if you pay some of your balance off, you may find that your credit limit has decreased accordingly. Relying on having access to credit is risky in this financial atmosphere, and could result in you having paid down a significant amount of debt but be cash poor and unable to borrow further funds.
Having an emergency fund of three to six months’ worth of expenses can help alleviate the risk of getting caught short.
Matching 401(k) Contributions
When assessing whether it makes more sense to pay down debt or save for retirement, all of the inflows and outflows of cash have to be considered. If you work for an employer that matches 401(k) plan contributions, the potential “free” money could more than offset the interest that you would continue to pay on your debt by not paying it down. Most employers only match up to a certain contribution limit annually.
For example, assume that you have $5,000 with which you could either contribute to your 401(k) plan or pay down a car loan at 7% interest. If your employer matches up to $5,000 annually, you would get an immediate cash infusion into your retirement plan. That is an immediate 100% return on your invested funds, plus any ongoing investment return in the portfolio.
On the other hand, if you pay $5,000 down on your credit card, you are saving approximately $350 per year (using simple interest). It would take many years of carrying the extra $5,000 in debt to make up for the savings realized by contributing to the retirement plan. Consider contributing at least up to the matching ceiling before paying down existing debt.
Early Withdrawal from a Retirement Account
The zeal to pay down debt can sometimes be so strong that people consider pulling money out of their retirement accounts to pay down the debt. For traditional IRAs, 401(k) plans and other similar products, this can be expensive. These plans are tax-sheltered, meaning the funds were not taxed on the way in and will be taxed when withdrawn.
Paying tax on these funds now can hurt your retirement strategy, as that money is no longer available to grow on a tax-deferred basis until your retirement. Even more damaging is the potential penalty that the IRS can levy for early withdrawals.
If you are under 59 1/2 years of age when you withdraw the funds, you will have to pay a 10% penalty on the withdrawal. That penalty can easily erase any benefits you receive by paying off debt.
The Bottom Line
Deciding whether it is best to pay down debt or build your savings depends on many circumstances that are unique to your financial situation. Choosing unwisely can have significant long-term financial repercussions. It is important to review your situation with an experienced CPA or financial consultant prior to making any large financial decisions.
“When Paying Down Debt Doesn’t Make Sense” was written by Angie Mohr for Investopedia.com.