Pay Off Debt? Or, Save for Retirement?

Fifty-six percent of adults under the age of 44 have student debt, according to the Pew Research Center. This is the highest share in history. The increase in college costs and the rising importance of a post-secondary education for improving income are a big part of this. Many surveys conducted in recent years have discovered that Millennials share a resistance to debt, no doubt influenced by coming of age during the dot-com crash of 2001 and housing crisis of 2008. Given this, it’s no wonder we often see younger people want to pay off debt before they save for retirement.

For those under age 40, retirement may seem like a lifetime away while currently your debt may be staring you in the face, inducing anxiety. If you looked at the amortization schedule of your new mortgage, you probably felt a spike of adrenaline and thought, “I’m paying this off as soon as I can!” But setting emotions aside, there is a rational way to make your decision.

To boil it down to its simplest form, think of your debt as an investment and the interest rate as a rate of return. Compare your debt interest rates to the expected rate of return on your other investment opportunities, and you’ll have a good starting point. If your student loan is locked in at 5% over 10 years and the expected return in your 401(k) is 8% over that time period, all else being equal, the 401(k) is a more attractive place to put your money. And remember, an employer match on your 401(k) contribution is an immediate 100% return, and you just can’t beat that. Do whatever is necessary to get your match as long as you’re not missing minimum payments on your debt.

Some interest expense is tax-deductible, making holding the debt more attractive if you itemize deductions. Examples of this are primary home mortgage interest (to the extent interest expense is greater than your standard deduction) and, depending on income level, student loan interest. Compare the benefit of this tax deduction to an investment’s expected rate of return by converting the debt interest rate to a tax-deductible equivalent yield. To do this, multiply your debt interest rate by 1 minus your marginal tax rate. For example, if your student loan interest rate is 5% and your marginal tax rate is 22%, multiply 5% times 78% to get 3.9%. Therefore, 3.9% is essentially what you’re paying in interest due to the tax savings from the debt. Compare this to your 8% return opportunity, and the prospects for investing are even sweeter.

A variable interest rate can complicate the analysis. Consider whether your rate is scheduled to go up in predictable increments. If so, you can look at your interest schedule, determine at what point in the future it no longer makes sense to have that debt and then plan accordingly. If your debt interest varies based on market factors, such as the prime rate, all other factors being equal, consider paying this debt off quickly in a rising interest rate environment and more slowly in a declining interest rate environment.

Having too much debt can be risky. If your debt level is to the point that an unexpected curveball will make it all come tumbling down, you should prioritize getting your debt to a more manageable level. However, don’t make the mistake of putting critical retirement savings on hold for the sake of blindly paying down debt. Younger investors have the luxury of time and can generally withstand more investment risk. Investment risk leads to higher returns over the long-term, and higher returns lead to a more comfortable — and possibly earlier — retirement.

Harli Palme, CFA, CFP®
Chief Operating Officer, Chief Compliance Officer

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