Saturday, August 9, 2008

To Save or Pay Down Debt?

This is the million dollar question for most people in debt: Is it better to pay off the debt as soon as you can, even if it means not saving? Or is it better to save while you retire debt? If so, how much should you save?

I, of course, did something totally irrational for the past 7 years: I saved for retirement while incurring additional debt, and put away nothing in my savings. (At least I have a decent nest egg though.)

The best common sense advice I received was: I should save until I have at least $500-$1,000 in my emergency fund and contribute up to the company match in my 401k (i.e., 6% of pre-tax income). After basic necessities (i.e., food, rent, utilities) are paid, I should use the remaining money to pay off debt exclusively.

Sounds reasonable. Is it really better for me to reduce my contributions to 6% and use the difference to attack my debts? I was curious, so I crunched the numbers to resemble my current financial reality as closely as I can.

For simplicity’s sake, let’s suppose I earn $100,000 and I’m in the 19% federal tax bracket and 9% state tax bracket. (Let’s also assume that I’ll be in the same tax bracket regardless of whether I contribute 6% vs. 15%. This isn’t realistic, but I’m simplifying here. Work with me.)

Let’s assume I have $127,000 in debt with an average APR of 6%. (THIS is depressingly real.)

I am currently contributing 15% to my 401k and paying approx. $1,900/month towards my debt. Under this scheme, it would take me approx. 82 months to pay off my entire debt. Total interest paid: $27,001.

Now let’s assume I reduce my 401k contribution to 6% and apply the additional $540/month towards paying down my debt instead. I will be out of debt in 60 months and I will have paid $19,811 in interest. Total interest savings: $7,190 total. Since I will be out of debt early, I also have the ability to save the $2,440/month that I was paying towards debt. Assuming a 5% return, I will have $53,382 saved after 21 months.

However, let’s not forget the compounding opportunities that I would give up by reducing my 401k contribution from 15% to 6%. Using a very conservative 5% return every year for 60 months, I gave up $36,619 in my retirement account by reducing my contributions.

So what’s the finally tally? By contributing 15% to my 401k, I will save $12,600 in taxes (over 5 years) and will earn an additional $36,619 in my 401k. By contributing 6%, I will get out of debt 22 months earlier, save $7,190 in interest, and have the opportunity to save an additional $53,382 during the 22 months.

In this scenario, I do indeed come out ahead by reducing my 401k contribution and using the extra money to pay down debt. But I’ve also used assumptions that were leaned in favor of reduced contributions. For example, the scenario assumes that I will use the extra money exclusively to pay down debt. It also assumes that once I pay off my debt early, I will put the money I was paying towards debt into savings. (Yeah, right.)

What influences my decision more importantly though, is that the stock market is currently declining. If I reduce my 401k contributions now, I fear I am losing a great dollar-cost averaging opportunity. For this reason alone, I’ve decided I will stick with the 15% contribution.

But what about savings? I’ve always heard one should have at least 3 to 6 months of expenses saved in liquid funds. (Suze Orman recommends 8 to 12 months!) Although $1,000 will likely cover most emergencies, I would probably need more since I'm likely to be laid off in December.

So what is the optimal amount I should save every month in my “rainy day fund”? I don’t know. But at this point, all I know is that I can comfortably put away an additional $100/month into my EF. If I used the additional $100 to pay down debt instead, I’ll only shave off 6 months off my final pay-off date.

On the other hand, if I save $100/month with 3% interest, I can save an additional $8,953 during the 81 months I hypothetically need to pay off my debt. (When my debts are all paid off, this should cover approximately 3 months of my living expenses.) Since this will give me a greater peace of mind during the repayment period, I've decided to contribute to my EF bit by bit rather than using the money to pay down my debts faster.

In summary, my current financial plan is: 1.) contribute 15% to my 401k, 2.) pay $1,900/month towards my debt, 2.) save an additional $100/month in my emergency fund.