Debt Reduction vs. Retirement Savings

I recently received an e-mail from a reader named Chris, who is in his early forties. He and his wife are working on paying off a car loan and a mortgage, and

We owe about $10, 000 on a car loan and $105, 000 on our mortgage, and we have two newer vehicles. I recently calculated that if my wife and I stopped our 401(k) contributions (mine 6% with a 50% match; my wife’s 8% with a 50% match) that we could pay off our car and our mortgage in eight years (maybe a little faster if we’re REALLY disciplined).

Eight years is a bit magical in that we’ll be just shy of 50 years old, and our oldest will be graduating from high school. My thought is that we’ll then start to save for replacing our vehicles and start to make contributions to our retirement funds again. We’d save about $64, 000 in interest, so I thought it might be the way to go.

Being debt free has a great draw to us — probably more than giving up the wonderful company match on the 401(k) plans. What are your thoughts?

Without knowing all of the details (e.g., income level, mortgage terms, auto loan details), it’s hard to say for certain. However, I would personally think long and hard before stopping those 401(k) contributions. Not only will they be giving up a ton of free money (the 50% match), but they’ll also be giving up the opportunity to stash that money in a tax-advantaged account, as well as years of tax-deferred compounding on the principal plus the match. Moreover, once those debts are paid off, they’ll have kids in college — this may wind up being yet another impediment to investing.

If it were me, I would most likely maintain the 401(k) contributions, tighten my belt a bit, and focus on getting rid of that auto loan. The mortgage (assuming that the terms are reasonable) is much less of a concern. Not only does it likely have a much lower interest rate, but the interest payments are also tax deductible.

Bottom line: While being debt free is an admirable goal, my view is that you really need to look at the big picture when making decision like this.

What about you? Any advice for Chris and his bride?

25 Responses to “Debt Reduction vs. Retirement Savings”

  1. Anonymous


    You should probably consider balancing out your 401k money with putting money into a Roth IRA since that won’t be taxable–especially if you have maxed out any company matching (if you get any). Best wishes.

  2. Anonymous

    Have you looked into the future, when you retire Uncle Sam is going to take a huge pecentage out of your 401k.
    I am 50 yrs old I have $ my 401k and at age 70 the government will make me take that money out and the first tear and every year after that I will have to give back a minimum of $9000.00 to our wonderful government. I say stop contributing to your 401k and and pay down your mortgage.

  3. Anonymous

    This is Chris–the guy who first asked the question… Thanks for the advice. I went ahead and paid off the car loan, and we did cut back quite a bit on my wife’s 401(k), although I’m funding mine with enough to get the full company match. We’ve also refinanced and gotten down to a 4.5% mortgage rate. Now, we’re taking a new approach. We borrowed about $6,000 (total system cost $8,100) to purchase a solar hot water system (heats my hot water) since the state of Pennsylvania and the Federal Government are being generous enough to pay for over 1/2 of the system (I’m finally getting some return on all those taxes I pay.) Final cost for the solar hot water system once I get my federal tax return will be about $3,800 As soon as that loan is paid off in early 2011 we’re going to fully fund my wife’s 401(k)–enough to get the match. Then, we’ll probably put the extra money into a Roth IRA rather than paying extra on the mortgage. In the future we’ll put any raises we get toward savings for eventual car purchases. If we can afford to take money out of they Roth IRA later, we’ll take out our contributions to help our children with college–if we can’t afford to take it out and need it for retirement, the kids are pretty much on their own. Perhaps we can help them pay off their loans later 🙂 Any thoughts?

  4. Anonymous

    Laughed out loud when I saw the closing line asking if anyone had any advice. Oh, we *all* have advice.

    Seriously, Chris, make yourself a couple of spreadsheets — it’s the best way to convince yourself. Like most readers of this column (you realize this is a biased group), I expect your best option is to keep your 401k contributions as they are, and to quickly pay off the auto loan in any other possible way.

    But, don’t take our word for it. Bust out your favorite spreadsheet app, and forecast the next twenty years for each approach that you’re considering. In each spreadsheet, keep every factor the same except for the ones you’re asking about. Then see which one pays you the most by age 60, the IRA free withdrawal age.

    (If you like, see what happens if you need to withdraw the IRA money at age 50 or 55. I bet the full-IRA-contribution approach still saves you money even with the penalty.)

  5. Anonymous

    Don’t give up the 50% match! Also the 401k is deferred taxes now which is great. It’s possible when they retire the couple might not be drawing their entire retirement from the 401k, thus they could save on taxes.

  6. Anonymous

    A lot depends on interest rates on the loans and on how much extra money they have available for emergencies. In terms of emergencies, in this economy I’d consider a worse case scenario e.g. 2 years out of work.

    I wouldn’t rush paying off the mortgage loan unless you really believe we get long term deflation like in the 30s or in Japan. If you think the government’s printing money will not allow deflation but may result in large inflation, then low interest loans should be kept for as long as possible: the inflation reduces the value of the payments. As soon as the economy starts to improve, the government will have to raise rates to combat inflation caused by these huge amount of money they printed. As soon as this happens, the interest paid on banks’ saving accounts and CDs will go up. It’s quite probably that in a few years banks will be paying 5% or 6% on CDs, maybe even more. If the mortgage interest is lower, extra money saved can earn more interest.

    Morgage vs 401K – assuming good mortgage rate, I’d take 401K. Whether or not you want to contribute additional money (after 401K) to mortgage or to simply put money in a bank depends on a) whether you have enough money in a bank for really serious emergencies b) what you think about chances of future inflation c) your personal preference i.e. would you rather hedge against inflation or live in a paid off home.

    As to car vs 401K – if the car loan is at an OK interest I’d take 401K up to company match then a car loan. I wouldn’t consider car loan a hedge against inflation because it is too short term. If a car loan is at variable interest or high interest, I’d pay off the car loan. I’d also consider if I would be able to easily afford the payments if I am out of work and if I have enough in savings. If not, I’d rather get rid of the loan to minimize the expenses in future.

  7. Anonymous

    @15 Aggieann. Sure!

    My husband is a teacher so during the week after school he tutors students. Once every other month or so on a saturday he teaches technology to other teachers (ipods, blogs, etc.). He is also a Title III coordinator, soccer coach, and yearbook teacher. These all get stipends. Not much tho. So he may tutor next year through Sylvan learning center and not go through the district. He also works summer school and does workshops in the summer. My husband makes $20/hr for his tutoring and $80/hr teaching teachers. He will be a master technologist as soon as he takes the last exam. He LOVES teaching. He stays late even when he doesn’t have to. AND he gets there early.

    I”m having more trouble. I’ve never found something I love to do. I’m an insurance adjuster and my company won’t let me do anything insurance related outside the company.

    Originally i volunteered for catstrophe services, where i traveled a LOT. But i got $1000 extra per month, plus overtime (maybe $200 a month, but only 4 months a year), plus perdiems (anywhere from $32 to $61/day take home). It was too much stress, tho. I took what amounts to a $15,000 pay cut to move to this position last May (We got married last January). So for my part, I’ve been concentrating on saving money on groceries and other purchases (where can we buy cheap but good quality cloth diapers, etc.), getting to know the real estate market for when we do buy the house, etc.

    I can’t think of anything that would make 10 or more dollars an hour that will work around my weird work schedule (I have to stay till 7 one day every other week at least, and I work one sat a month.)

    If you’re looking for ideas, my cousin was a marching band teacher and even in high school he wrote the choreography for most of the local university marching bands. A friend in college made $15 an hour teaching windsurfing. He worked in a surf shop and got customers that way.

    A friend is a warehouse manager and he got a side job setting up/taking down moonwalks at kids birthday parties. Saved all his money and bought one. Put an ad in the yellow pages. Literally. That was his only advertising. Kept working for the other guy and kept saving up his money with his moonwalk till he had 5 moonwalks. He makes about $3000 a month in the warm months.

  8. Anonymous

    I’d be careful here. He’ll have two cars at least eight years old with no cash on hand at the end. I’d keep a small cash pile for emergencies, at the least. Going all in means going all bust is a more likely scenario…I’d play it more conservatively.

  9. Anonymous

    What Chris needs is a comprehensive plan.

    Initial Step: Budget
    Chris and his family need to learn to live on a written spending plan that is prepared each month before the month begins.

    Free Budget forms are available at:

    Step 1: Starter Emergency Fund
    Chris and his family should save $1,000 to $2,500 as a starter Emergency Fund

    Step 2: Become Debt Free (except for the house)
    At this step Chris and his wife would temporarily stop their 401K contributions. You stop the 401K contributions as a means to fully harness the power of focused intensity at eliminating your debt.

    Step 3: Build a fully funded Emergency Fund
    Chris and his family should save 3-6 months of expenses

    Step 4: Retirement Savings
    Chris and his family should save 15% of their income for retirement. At this step Chris and his wife should resume their 401K contributions.

    Step 5: College Savings
    Save for kid’s college or cash flow current college expenses as Chris and his wife are able to based on their income

    Step 6: Pay off the House

    Step 7: Build Wealth

    What’s amazing about this plan is that it works for everyone!

  10. Anonymous

    If you want the best of both worlds, sell the car and pay cash with the equity in your debt mobile. Then sell your house and pay cash for a smaller place (even a condo) with the equity in your home. Max out your retirement. then with the rest of the cash you were using to pay down the house, put in ING, etc. and get second jobs. then pay cash for your new home.

    Do something you love on the side that you would do for free, but get paid for it. My husband and i are doing this. I will be 40 in a few months, we make about $40k each, and we expect to pay cash for a house in five years with no second job and pay cash in fewer years with second jobs. and that’s with starting a family next year. Also, we are keeping the condo as a rental. If you used the condo/smaller place’s equity to buy your new home, it wouldn’t take you so long to save for your house.

    When was the last time you did something different and weird? We think of it as an adventure. I get excited every time i come home, thinking of how financially solvent we are going to be. And downgrading has allowed us to almost live on 1 income. can’t quite live on one income but we are close! Good luck!

  11. Anonymous

    Well they can probably downgrade the cars because really you are paying interesting on a car that will be worth 50% in 5 years.

    I would say that their situation is pretty good compared to others in their age. I mean its not great but its not horrible.
    I say they should speed up the process to pay off the debt by either downgrading, cutting back and making more money.

  12. Anonymous

    I think the better question is: Are you disciplined enough to maintain that debt payoff structure for EIGHT years? That’s a long time and a lot can happen. On the other hand, once you’ve learned to live on your salary less your 401k contributions, it gets to be pretty easy.

    Personally, I would find an alternate source of income to reduce debt other than ceasing those 401k contributions.

  13. Anonymous

    Perhaps reduce contributions if they HAVE to. But do NOT stop them! Retirement is all about compounding interest. If they wait 8 years… Well, here’s my favorite example (swiped from “Deal With Your Debt”):

    A woman contributes $3,000 a year from ages 22-32. She then stops and never again contributes.

    Her twin sister goofed around and didn’t start contributing until age 33, but she contributes $3,000 for the next 30 years.

    Who has more money? The first woman — even though she only invested a total of $33,000, whereas her sister put in $90,000.

    It says a lot about compound interest. If they want to pay down the other debts, I suggest they either get second jobs or find more to trim. Otherwise, they’re really just cheating themselves.

  14. Anonymous

    First, the 50% match isn’t free money. it is a calculated part of your compensation package.

    Ask youremployer if your stop the 401Kif they will somehow compensate you for the now deferred 50%match. It is actually the same costtothem,so you never know.

    2nd. 50% is nice…when the market goes up. when it goes down, thats 50% more going down.

    3rd. Justbecasue it is mortgage interest doesn’t mean the tax deductibility matters. Unless this guy haslots ofother deductions, the interest on 100K is far shrt of the married standard deduction. Solikely the deductibility of the mortgage doesn’t apply.

    4th. Debt redcution is risk free. 401K investing is not.

    Calculate you appetite for RISK. then decide.

    Forget the compounding argument. BOTH liabilities and assets compound. The rate of compounding is what matters, not the classification.

    Me. I would payoff the car and house. It is risk free and guaranteed. Forget the 401K. and the “freemoney” 50% match. that is simply more money you will loose in the market, And what you don’t loose will be taxed when you do withdrawal from the account.

    The 401K aint all it’s crackedup to be. Just ask themillions who have one how they like it after the last 18 months.

    Debtfree is all its cracked up to be. Ask those who are and you will not hear very many “gee, I wish I owed more” comments.

  15. Anonymous

    hmmm these kinds of questions do have right answers – if you have all the variables. Is it that hard to put the scenarios into a spreadsheet and run some sensitivity analysis to get the right answer – rather than guessing?

  16. Anonymous

    You cannot pass up the employer match that equates to a 50% return on your investment – much higher than they would get paying down debt. If they are not at the maximum for the employer match, they should increase their 401(k) to that threshold before thinking about paying down the debt.

  17. Anonymous

    I wouldn’t pass up the 50% employer match on the 401k’s. Thats free money.

    They’d probably come out ahead overall just putting the money into the 401k in a safe investment.

  18. Anonymous

    You think about the timing of it all, and I don’t know if stopping right now is the best thing, especially because the stocks you’re going to be buying right now are going to be on sale! It’s a great time to be putting money into the market!

  19. Anonymous

    You don’t give up compounding — you pick what you want to compound. If your assets earn more than your debt costs, you might want to add to those assets — unless there’s a risk that your assets will drop in price, and you’ll have to sell to pay off your debt and end up with no assets and some debt.

    So some of it is a question of risk preference. What would keep you up at night more? Having enough savings to retire on, but owing $100K on your house? Or being debt free, but still $100K short of where you need to be to retire?

  20. Anonymous

    I disagree in part. Paying down the auto loan should be yoru #1 priority as that is not tax deductible. Take your time with that mortgage payment as that interest is deductible (unlike the car).

    401(k) offers no taxes now, but you will pay those taxes later on a much higher amount (all that principal, and compounded interest). However, keep in mind your deductions will long be gone (e.g., no more mortgage interest to deduct, no kids to deduct) and possibly you will be in a higher tax bracket. Not to mention there is a possibility taxes will be higher in the future than today (they certainly won’t be lower!). THe 50% match helps soften this blow so your 401k is worth as long as that is the case. Thus, attack that auto loan, save for retirement under 401k (keeping in mind what I just said), and deal with the mortgage last

  21. Anonymous

    I’m on the same page: passing up an employer match just doesn’t make sense in terms of return on your money–unless your car loan or mortgage have particularly heinous interest rates, I suppose.

  22. Anonymous

    I say continue contributing to the 401(k). You’re not going to get free money any other way. I’d say do the math and find out how much compounding you’d lose, approximately, compared to how much interest you’d have to pay.

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