When you have extra money at the end of the month, should you pay down debt or bulk up your retirement savings?

Ask this question at a party of financial advisors and you’ll get as many different answers as there are attendees. That’s good, because it’s a very personal decision. The answer should always depend on an individual’s financial situation and their emotional relationship to money. That said, there are a few useful guidelines to follow, and the answer that’s best for you might not be as obvious as you think.

How to Pay Off Debt and Save for Retirement

When you ask for advice on whether you should pay off debt or save for retirement first, you’ll quickly encounter the crowd that thinks all debt is bad. They’ll tell you to pay off your credit card balances, car loans and even your mortgage as soon as possible.

There are legitimate reasons for this point of view—and from a behavioral standpoint, it’s a simple rule that’s easy to follow. It works for some people.

Equally as passionate is the group we’ll call the “pay yourself first” believers. They argue that not all debt is created equal. A personal bank loan with an 11% interest rate is hardly in the same class as a 3% home mortgage. Pay yourself first-ers believe there is “bad debt” and “good debt.”

The pay yourself first faction offers their own simple rule: If you can invest the money and earn a greater return than the cost of debt you are paying, why not save for retirement first?

The S&P 500 has a long track record of earning roughly 7% returns over the long haul when you account for inflation. So why pay down a 3% mortgage and throw away the chance at higher returns? The math becomes even more persuasive when you consider tax deductions for mortgage interest and the potential for decades of compound investment growth.

“You’ll be paying bills for your entire life; you might as well take care of yourself first,” says John Thomas, a retiree in Cambridge, N.Y.

As always, the truth is somewhere in the middle, and where you fit in that middle ground depends on your circumstances. Follow these five simple steps to figure out the right course of action for yourself.

1. Evaluate Your Debts

Start off by taking a long, hard look at your debts. Most people have a spectrum of debt: college loans, car payments, a few credit cards, maybe a mortgage. List your balances, your minimum monthly payments and, most importantly, the interest rates you’re paying on each balance.

Regardless of whether you consider yourself a “pay yourself first” or “all debt is bad” person, you’ll want to make sure you’re putting at least enough to meet minimum payment requirements. Then you can turn to interest rates.

Any debts that require you to pay double-digit rates, such as credit card balances, should stick out. Revolving credit card debt is poisonous to most consumers. That’s why even the most strident “pay yourself first” folks would suggest paying down those debts with all haste. Then you might move onto your lower-interest debt and investments.

But before you start paying bills, proceed to the following tasks.

2. See If You Have a 401(k) Match and Maximize the Match

If your company encourages retirement savings through some kind of matching arrangement, like a 401(k) match, even “all debt is bad” proponents would recommend you invest at least enough to capture that free money.

If your employer pays you 50 cents for every $1 you put away up to 6% of your salary, that’s a 50% return right away, or when the savings vest. That high return leads most financial advisors to prioritize it over almost all non-mandatory debt repayment.

3. Build an Emergency Fund

The most expensive mistake many consumers make is not planning for emergencies. The car needs a new transmission, your landlord raises the rent, you lose your income. The exact nature of emergencies isn’t predictable, but having some kind of emergency is all but guaranteed.

And if you have to pull out an expensive credit card or take out a personal loan to pay for whatever that emergency is, a year or two of responsible savings can go up in smoke. That’s why you should work on building a good financial backup plan even as you pay down your debt.

“I keep 10% for savings to keep myself from going into debt further,” says Heather Young, a 34-year-old, Seattle-based IT worker.

Generally, experts recommend you have three to six months of living expenses socked away in a safe place. You shouldn’t invest this money in stocks or stock-based funds; it should be as liquid and easily accessible as possible, like in a high-interest savings account.

If you can’t afford to meet your minimum debt payments, build emergency savings and save for retirement, you have options. For instance, you can save for an emergency today while also preparing for the future with a Roth IRA. Money deposited in a Roth IRA can be withdrawn without incurring penalties or taxes, making this individual retirement account an ideal impromptu emergency fund if you need money in a pinch.

A couple of words of warning, though: Any earnings your money makes, whether that’s interest, market returns or dividend payments, cannot be taken out without a 10% penalty plus taxes. You’ll also want to keep the funds you placed there in safe investments, like high-quality, government bond funds or money market funds. Once you have sufficient emergency savings, you can start making your investments more aggressive and stock-based to help you grow wealth for retirement.

4. Make a Debt Repayment Plan

Once you’re meeting your minimal debt obligations, have built up your emergency savings and have maximized the free money you get to save for retirement, it makes sense to take what’s left over each month and consider a blend of debt payments and retirement investments.

But which to prioritize first? Your calculator might tell you to pay off the highest-interest, highest-balance debts first and then to invest once you’re left with debts that will cost less in interest than market performance will earn.

While that may make the most sense mathematically, human nature and cognitive biases sometimes prevent us from making the most logical financial decisions, says Jeff Kreisler, head of behavioral science at J.P. Morgan Private Bank. One example: something behaviorists call “hyperbolic discounting.” We incorrectly discount the value of cash in the future.

“We’d rather have $10 today than get $15 in a month. That’s because we’re emotionally connected to our present,” says Kreisler. Ever stronger, for many people, is the pull of loss aversion. We hate losing money. We hate it so much that we get angrier about paying a $20 parking ticket than we are happy when we find a $20 bill. Oftentimes, we’d need to win double the amount we’d lose to negate the pain of loss.

“We are more likely to act to avoid loss than to achieve gain,” Kreisler says. “We know we’re losing money every month to our debtors, so we’re going to be more motivated—often unconsciously so—to avoid that loss [through paying off debt] than to pursue the gain of saving for retirement.”

But the cost of that can be much higher than we realize. Over decades, the S&P 500’s roughly 7% average gain means money doubles about every 10 years. That means every $1 put away at age 25 could be worth about $16 at age 75. Delay retirement savings by 10 years, like you might if you waited to until you’d paid off your student loans, and that $1 is only worth $8 at age 75. Take that same dollar and use it to pay off a 5% student or car loan a little early and you’d only be saving yourself a few pennies of interest costs.

The Psychological Counter-Argument

Doing things solely by the math of the situation doesn’t work for everyone, though. Sometimes, you need the faster gratification of quick debt repayment over retirement balances decades in the future.

This psychological pull is one of the factors motivating Heather Young’s debt repayment. “I focus on debt because the sooner those are paid off, the less money in interest I have to pay and the more money I can keep. The snowball method is really working for me,” she says.

The snowball method suggests paying down the debt with the smallest balance first to give you a quick “win” and let you enjoy the rush of eliminating one bill. Then, snowball adherents tackle the second-smallest bill. This hopefully creates virtuous momentum, like a snowball rolling down a hill.

How you choose to repay debts, though, is ultimately less important than getting into the practice of regularly making some kind of debt repayment.

5. Maximize Your Retirement Contributions

Once you’ve got your debt squared away, you can turn to maxing out your retirement contributions.
Many retirement savers make the mistake of maximizing their 401(k) employer matching contributions and…then stopping there. Your employer might stop giving at 6%, but there’s no reason you can’t contribute 10% or 12% of your salary into that tax advantaged account. Or more, up to $19,500 annually (or $26,000 if your 50 or older) in 2021. And once you’ve maxed your 401(k) out, you can turn to traditional or Roth IRAs to save even more. These tax-advantaged accounts could save you thousands in taxes over your lifetime.

While the combined $25,500 ($33,000 if you’re 50 or older) that you can contribute to a 401(k) and IRA may seem like an excessive amount to save for retirement, maximizing your retirement contributions early on can have an outsized impact on your future financial stability.

Consider this Parable of the Two Twins: One invests from age 22 to age 32 and stops; the other invests the same amount each month from 32 to 62. Assuming similar average annual returns, guess who has more money at age 62? That’s right, the twin who started early but saved for only 10 years. This may seem almost too good to be true, but it’s not: See the math here!

This highlights the importance of saving early for retirement when you’re young and dealing with moderately priced debt. And even if you aren’t fortunate enough to max at your contributions early in life, you can still benefit from the growth of smaller contributions over years or decades.

Pay Off Debt Or Save For Retirement?

There’s certainly nothing wrong with using extra cash to pay down debt every month. Maybe you are the kind of person who thinks if the money is sitting there in a retirement account, you’ll use it and lose it, so you’d rather pay off debt. Or perhaps you just sleep better at night without feeling like you owe someone money. It’s hard to put a price tag on a good night’s sleep.