First off, let’s accept the fact that we all have debt, but to make it very clear, I don’t believe in never borrowing. In a time of need, a loan handled properly can be of great service. At the same time, you also hope to have wealth and retire one day. You need to start investing your money, eliminating your debt, and saving up. Both require money and both require a real commitment. One of the most frequently debated topics is whether one should pay off debt first or invest?
Let’s first acknowledge the fact that a major hurdle to financial success is debt. Nevertheless, there are two very distinct kinds of debt, there is debt that is beneficial, termed "good" debt, and there is detrimental or "bad" debt.
The real obstacle to successful financial management is investing in bad debt. Good debt is money you borrow at a low interest rate, with which you make a high rate of return.
A common example is money you borrow to buy a business. The debt is dealt with by the income produced by that business.
Bad debt, to the contrary, is consumer debt. This is money that you borrow at a high-interest rate to purchase things, that don’t produce income or increase in value. These are things like cars, big screen televisions, clothing and (one of my favorites) trips to the Caribbean.
We all have done it at one time or another and, ultimately, we’ve all paid the price.
The cost of bad debt is the burden of compounding rates of return acting against you rather than for you. If you have credit cards or bank loans that cost you 18% or more a year, that’s 18% compounding against you building wealth.
Before you are able to start saving money, and ultimately making money, the one and only rule is to not lose money!! So, the number one thing most of us must do to become successful is to pay off bad debt.
If your investments have a rate of return of 15%, and you have credit card debt that you’re paying 18% on, in essence that means you’re borrowing money at 18% and making only 15% on it.
For as good as we’re doing well as an investor, we’re going backward at a rate of 3% compounded per year. That’s not only a heck of a barrier to successful investing, were going backward.
Doing it this way will never build wealth, unless you hit it big in the lottery, otherwise, you’re headed straight into poverty.
Now just realize that if we flip the situation around, and take the money we were going to invest, and instead pay off the 18% interest rate debt, and then instead of losing 3% a year, immediately, even if we don’t have money left to invest, at least we’re breaking even. Think about it, being in debt is far worse than being broke.
While all of this may be true, there is another side to the debate.
FOR THOSE WITH STUDENT LOANS
Juggling the monthly payments of student loan debt is often the leading factor that causes millennials to put off saving for retirement. While young professionals are always advised to save now rather than later, a recent study from Morningstar shows the impact student loans can have on retirement savings (1).
According to the new report, which includes data from the Federal Reserve, each additional dollar toward student loan debt decreases your retirement savings by 35 cents. That means someone with $100,000 in student loans can be set back by $35,000 in retirement funds.
With the average student loan debt for recent graduates having reached a little more than $35,000, the likelihood of millennials saving for retirement is slim. According to a Bankrate survey, 18% of adults between the ages of 18 and 29 say they owe too much in student loans to even consider saving for retirement (2).
While the idea of getting rid of your student loans quickly sounds appealing, putting all of your money toward paying extra on your loan is not exactly the smartest thing to do. Pace yourself with your payments and if your budget doesn’t allow you to give more than the minimum required then don’t force it.
A professional, who starts saving for retirement at 25, starting with $1000, and putting away just $2,000 a year for 40 years, will earn around $563,000 in savings, assuming earnings grow 8% annually. If a professional waits until they’re 35 to save, putting away the same $2,000 a year but for 30 years instead, they will end up with less than half the same amount of money at $246,806. Finally, A professional who starts saving for retirement at 45, starting with $1000, and putting away just $2,000 a year for 20 years, assuming earnings grow 8% annually, will earn around $100,295 in savings. That’s 18% of the same $2000!
For young professionals who are looking to save on retirement now, be sure to enroll in your company’s 401(k) plan and take advantage of any matching they offer. Also, with more companies helping employees to pay off student loan debt make sure to ask your employer if this option is included in your benefits package.
Now, for the rest of the debt you may have accumulated, you’ll need to take action to begin to eliminate it.
- Spiegel, Jake. "How Student Debt Affects Retirement Wealth." Morningstar Advisor. N.p., 14 Apr. 2016. Web. 27 May 2017.
- Steiner, S. Why can’t millennials save for retirement? Bankrate, Retirement, March 20, 2017
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