Paying Down Debt Vs. Saving
After we’ve done the work to have a bit of a monthly surplus (where our net income exceeds our expenses), we need to figure out how to deploy that surplus to make our money go as far as possible. This is part of the process that I call ‘savings optimization’, but we aren’t necessarily going to deposit that excess money into a savings account at the bank or for retirement. This is especially true for folks who are servicing debt.
Why? Well, when we’re servicing debt, the interest rate can be hurting us more in the long run than the money that we would earn by contributing the money to some sort of savings vehicle. If you’re carrying high-interest debt, this really applies to you.
But what is our tipping point? How do we decide if we’re going to be better off saving or paying off debt? It’s incredibly situational and working with a financial planner like myself can help you figure it out, but here are a few tips to get you thinking in the right direction.
Employer-sponsored plan match
We’re always looking to maximize our money, right? Sometimes that means saving a few dollars on an item that we buy. Other times that means just making the most of programs that are available to us. After all, investments aren’t the only way for us to potentially make our money work a little harder!
One of the best ways to make your money go further is by taking full advantage of your employer-sponsored retirement plan employer match and this is where I typically recommend folks start in the saving versus debt pay-down conversation.
An employer match is a promise by your employer to match the contributions that you make to your employer-sponsored retirement plan. It is often expressed as a percent of your contribution up to a certain percent of your salary.
For example, an employer might match “50% of your contribution up to 3% of salary”. If this was your employer match, then in order to receive the maximum match you would contribute 6% of your salary. Your employer would then match half that contribution, which equates to another 3%. In this scenario, the total contribution would be 9% of salary.
Why is this important? Because our employer match is almost always dollar-for-dollar the best leverage for our savings. In the scenario above, the match basically locks-in a 50% return before exposing those contributions to investments.
Check with human resources or whomever handles your retirement plan at work to see if they offer an employer match. If they do, it might make sense for you to increase your contributions to a level that takes full advantage of that match. Even if you don’t think that you can afford it, give it a shot and see how it goes for a few pay periods. Those pay-periods might be challenging as you adjust your spending to your new cash flow, but your future self will thank you for the decision.
High-interest debt
After we’ve maximized our employer match, we need to find our next priority.
There’s a very important concept to keep in mind when it comes to our finances: net worth. Net worth is our assets minus our debts. It’s common for those of us who are in the early years of our careers to have a negative net worth. But, ideally, we want to work to increase our net worth over time.
While employer-sponsored retirement plan matches are likely to have the highest positive effect on our net worth of the options we’re discussing, high-interest (in the 15% and above range) debt has the deepest negative effect on our net worth. So, after we maximize our employer match, it’s likely that our next most efficient choice is to pay down high-interest debt. Typically this means credit cards and unsecured personal loans.
We’ve discussed a few different strategies for debt reduction. Be sure to check out the John’s Top Tips playlist on our YouTube channel for some of those insights!
A game of percentages and time
We all know that high-interest debt is toxic. So you might be thinking that paying down high-interest debt should be our priority over maximizing our employer match (especially considering compounding interest). This is a fair thought, so let’s break it down a bit more.
In the employer-sponsored retirement plan match example that we discussed previously, we talked about a conceptualized 50% positive ‘return’ simply for making the matched contributions.
In contrast, high-interest debts are theoretically causing a ‘return’ to our net worth of negative 15% or more.
We prioritize maximizing the employer match because it has a higher positive ‘return’ on our overall net worth than the high-interest debt’s negative ‘return’ on our net worth. If our employer match is 50%, and the interest rate on our debt is 25%, then choosing to put money into our retirement plan to receive the employer match instead of extra payments to our high-interest debt causes a +25% change to our net worth (+50%-25%=+25%).
The decision becomes more difficult when we’re dealing with lower interest rate debt versus unknown returns on our investments. Once we’ve maxed our employer match and paid down our high-interest debt, does it make more sense for us to apply extra payments to some of our lower-interest debt or to save?
One other thing to think about is the time value of money. We hope that our savings compound through investing and the longer we have a dollar saved and invested, the more time we give that dollar to grow. In some instances, saving instead of paying down lower-interest debt can lead to a higher net worth over time. This is where working with a financial planner who understands your situation can really help.
