How to Invest for Retirement While Paying Down Debt

Invest for retirement as a recent college graduate and you will likely be in a much better financial position than someone who begins saving later in their career. The effects of compounding interest all but guarantee a younger investor will have greater success in amassing wealth for retirement than an investor who starts later. But not all investments are good investments when trying to pay down debt. This article will explore what it means for two young people to come to their own retirement investment decisions; whether paying down debt should occur simultaneously with retirement investing; or whether paying down debt should replace investing.

A college graduate who lands a new job in a new city is one of the most in peril of doing irreparable harm and damage to their finances. Thrust into new circumstances, investing for retirement is one of the last things on their mind. Which is why a smart college graduate should be learning about budgeting her life outside of booze, movies, and going out gear. One such college graduate in the Washington D.C. metropolitan area noted to coworkers in response to her first couple of regular paychecks, "Wow, taxes take a lot." This former classroom student became a student of personal finance and of life when she quickly realized she had less money than she expected, and at the most inopportune time. She had been increasing her spending between a new apartment with higher rent and a new (used) car payment. To make things worse, she had amassed more than a little credit card debt buying a whole new wardrobe of work-appropriate styles.

As she budgeted, she discussed with friends that she would put "a little less in the 401(k) until the debt is gone." This is noteworthy. She did not forgo investing for retirement, nor forgo paying down the debt to maximize saving for retirement. Maximizing the 401(k) tax-deferred investment vehicle for retirement is smart, if you can afford it. It's almost always advisable to put just about as much money into your 401(k) as possible, and then move on to contributing to a Roth IRA and then look to other investment vehicles. So how did this recent college graduate know she was making the right decision?

She did not. At least part of her just found it more satisfying to pay down debt.

A personal finance enthusiast she spoke to had a similar experience several years after graduating college. Though debt was not a factor for him, when he first started working full time he put off contributing to the 401(k). Investing for retirement was incredibly important to him, but his life circumstances involved several large expenses, most notably buying and furnishing a new home, planning a wedding, and preparing for a honeymoon. Budgets had been evaluated and set for each, but the short term was bleak, particularly should one of them lose their job. The enthusiast was spending more than the income from the regular paycheck. He had a cash flow issue. If his bank accounts had been empty to start, the debt would have accumulated. He was lucky in that regard, but he deferred investing with an industry-leading 401(k) employer matching. So where did the personal finance enthusiast go wrong? "I couldn't imagine putting even a small portion into the 401(k) when we needed that money yesterday!" he said in an interview. An after-the-fact review of his finances indicated a healthy emergency fund and a checking account that would be dented, but not depleted by the new life circumstances. The personal finance enthusiast had forgotten to set short term savings goals in his budgeting. He was too focused on the negative balance that results when spending more than earning. He should have done as the recent college graduate did and put a little less in the 401(k) until the cash flow issue naturally went away after the honeymoon.

In the long term, you might get more out of contributing to the 401(k) and not paying down your debt so aggressively, but this would depend on your interest rates and investment style. Because credit card debt is generally high interest rate debt as opposed to student loan debt, the right order of priority is generally going to be paying down the high interest rate debt while sacrificing some or even all investing for retirement. Where the debt is a lower interest rate debt, it becomes a question of whether you will come out ahead with investing or paying down the debt. A student loan with a 4% interest rate might be a high interest rate debt if your investment style is conservative and mostly involves savings accounts and purchasing Bonds and Certificates of Deposit. If, on the other hand, you are an aggressive investor who expects to see 7-10% annualized returns for the next 40 years until retirement, you will come out ahead by investing for retirement and not paying down the debt so aggressively.

If they taught finance better in high school and college, fewer people would have these sorts of problems in their 20s and throughout life. We need better life skills training when it really matters.