How you respond to this question will likely determine how much wealth you are able to build. The answer is that it really depends on your situation, but there a few criteria to consider when trying to decide which path to follow.
Paying off High Interest Rate Debt
There are certain kinds of debt that are more destructive than others. These debts can quickly spiral out of control. I am talking about credit cards and payday loans – just to name a few.
These debts are created to intentionally trap those who use them. They lure their users in with low introductory rates and teasers, only to hit them with higher rates and payments only a few months later.
These debts can be so expensive that trying to build wealth without having them paid off may be counterproductive. Generally they must be dealt with before you can make progress in investing.
If you have a credit card that has a manageable payment and rate it can typically be managed with your other debts.
If you have any of these high risk debts, work with the lender or credit card company to see what can be done to lower these payments. They make more money by lending at higher rates, but they also want to be repaid. Having a more manageable payment will make it easier for you to repay them – which makes it more likely that they get their money back.
It doesn’t hurt to try, and you may be surprised by how willing they are to work with you.
Paying off Instalment Loans with Fixed Payments
These types of loans generally have a fixed payment and term. For example, a car loan usually has a term of around 5-6 years. The payment and interest rate are fixed during that period.
Auto loans usually have rates that are much lower than credit cards and payday loans. The exception would be if you bought your car through a buy-here-pay-here dealership. If so, try to refinance this with a local bank or credit union to get a lower payment if possible.
A mortgage is also an installment loan with a set amount of payments. Unless you did an adjustable rate mortgage your payment will be fixed for the term of the loan.
When considering if you should pay these installment debts off before investing it is important to look at the balance. Because a mortgage has a much higher balance, and will likely not be paid off for 15-30 years, it seldom makes sense to pay this off before investing.
A car on the other hand may make sense. If your balance is only a few thousand dollars, having this debt paid off will free up a large sum of money very quickly that can be used to pay off other debt or to invest. Student loans also fit into this category of installment and should be looked at similar to evaluating paying off an auto loan.
If your installment loans have poor terms your first goal should be getting better loan terms. If the terms are fair, look at the balance to determine how close you are to paying it off. If it is more than a year it probably makes sense to get started with investing and pay this off with your other debts.
Losing out on Compound Interest
The real risk of not investing is losing out on the power of compound interest. Compound interest is when your money is invested continuously and your interest is earning you additional interest.
As an example, if someone starts investing at 25 and puts $300 per month into a retirement account, when they retire at 65 that sum will have grown to almost $800,000 – assuming a 7% return.
If that same person starts investing at 40 and contributes the same $300 per month until they are 65, that sum will have grown to $245,000 – assuming the same 7% return.
I am sure your first thought is that the 25-year-old had contributed a lot more money – not as much as you might think.
In those 15 years of additional investing they contributed only $54,000 more towards retirement. That is nothing considering their retirement grew to more than $800,000 – which is $555,000 more than if they had waited until they were 40 to get started.
This is the power of compound interest. The earlier you get started the more powerful it is. Even waiting a few years to pay off debt can substantially decrease your retirement. Here is a more detailed example of compound interest.
There is always the option of trying to make up on lost time by contributing more towards retirement once debt is paid down. This is a possible, but once you get so far behind it will likely be impossible to do so.
This is the real danger of waiting until all of your debt is paid off to invest. You may be debt free which is amazing, but what has the cost been for your retirement? This must be weighed very closely.
Too many people are waiting until they are 40 to really get started on saving for retirement. In the United States, 24% of the current workforce has less than $1,000 saved for retirement. If a large percent of those are individuals that are 40+ years old they should be very concerned.
The silver lining is that it is never too late to start. Even if you are behind, there is still time to take steps to make sure you end where you want to. If you wait until you are 50+ it is going to be very difficult though.
Start by Contributing to Your 401(K) Retirement Plan
This is an obvious starting place for almost everyone. If your employer is sponsoring a 401(K)-retirement account you should be taking advantage of it. If you don’t have this option consider a Traditional IRA.
Most employers will match a certain percent of what you invest. This gives you an immediate return on the money you put in.
Regardless of your situation I think most people should start this sponsored 401(k) immediately. The rare exception would be someone who has very risky debt like a payday loan or high interest rate credit cards – even then it should be examined closely.
For the rest of us, the cost of waiting until being debt free is high when you factor in this lost growth. Start with whatever amount is necessary to get your full employer match and increase it as you pay down other debt.
Debt is a problem but not investing may be a much bigger one.
For most people they will be able to chip away at their debt until it is gone. With smart planning you should be debt free well before retirement.
The real question then is what will your retirement look like alongside your no debt situation? As you can see form our prior examples, the cost of waiting too long can be devastating.
Getting out of debt should be the primary focus for everyone – and will allow you to invest more once you are. Where I get concerned is where paying off debt takes front-stage and investing gets put on the back burner. Few consider the real cost of doing this because of their desire to be debt free.
If you are not investing today in your retirement I would encourage you to do so right away. If something is preventing you from doing it, your main focus should be getting past that obstacle.
If you elect to pay off debt before investing, make it a goal to be ready to invest as soon as possible – preferably less than a year. Having this goal in place will force you to be aggressive with your plans.
Time is your friend when you get started young, but will slowly become your enemy the closer you get towards retirement.
Get started today with investing towards your retirement – you’ll be glad you did!