Debt or Retirement: A Modern Day Sophie’s Choice
Jamie Dimon, CEO of JP Morgan, spoke at a financial conference once and said some interesting things. One thing that stuck out for me, all this time later, was his comment about American consumer health. He said we’re doing great in terms of debt. That’s what he said. What he meant was Americans are paying off their debts, and his vacations, at a steady pace. Banks track all kinds of metrics when it comes to consumer debt; however, the most important is months paid. Banks do not want you to default – best case scenario for them is when you pay the minimum payment for the life of the loan. A $5,000 credit card bill, at 18% and just paying the minimum payment, will take nearly 23 years to pay off and you’ll pay an additional $6900 in interest on top of the original balance. Ouch!
Because debt is such a huge financial killer, it tends to be a pretty common question asked by my friends. Usually, it comes with many parts – like, “how do I pay off debt AND save for retirement?” It’s a valid question. It generally looks like you have one option: debt OR retirement. It can seem impossible to save for retirement or even a tiny emergency fund when you have revolving credit card debt at 18% looming over your head. So, here’s some food for thought.
Make a Budget
A budget is the single most important tool for financial health and they’re easier than ever to make now. Google Sheets has an easy to use Monthly Budget template, built through Excel, that you can access for free and it autosaves to your Cloud if you have a Gmail account. I personally find that manually entering line items each month (I do it two or three times a month) and comparing it against my budget is the best way for me to stay on track. It forces me to visually, and physically, acknowledge my spending habits. If you’re a little less enthusiastic about your finances, there are many apps out there for you to use. Mint is probably the most recognizable; however, Wally and HomeBudget also score highly among user reviews. Side note, I’ve never used these products and cannot vouch for their usability – I use Excel and track my own budget.
Your budget needs to be an honest assessment of your finances. Many people use the 50/20/30 rule. This is a budget for your take-home pay that uses percentages to allocate funds. Your fixed expenses like bills, utilities, rent, and month to month subscriptions should not exceed 50% of your pay. 20% of your pay should be allocated towards financial goals – retirement, emergency funds, and financial goals like purchasing a big ticket item. Finally, 30% should be your discretionary spending that’s left over – people include groceries, eating out, and entertainment into this line. Personally, I’m more along the lines of 65/20/15. I make groceries a fixed line item per month. Sometimes I go over, but most months I’m around $30 under my food budget.
Once your budget it set up, it just becomes a matter of discipline and desire to be financially independent. Make it important to you and know that sometimes it will be hard. I’ve had to say no to going out to eat with family or friends simply because I couldn’t swing it in the budget; especially later in the month when I don’t have as much flexibility to control expenditures.
Debt or Retirement?
So here’s where I get a little different from most “money people” out there. Take a look at your financial goals section. Hopefully you have things like retirement fund, emergency fund, and incidentals (like your car breaking down) in there as line items. If not, consider doing it and if you need help sorting through retirement accounts check out this article. Now look at all of your debt: car payments, credit card, student loans, etc. You need to set up minimums that you will pay on these items, specifically your credit card and retirement contributions. Your auto and student loan payments are already set up, as is your mortgage if you own a home. This minimum payment needs to be a comfortable amount you could pay and still have some left over. This left over portion will be applied differently each and every month.
The only caveat to this rule is when it comes to credit card or house debt. If you have credit cards, PAY THEM OFF. Regardless of what the market does, you will not get 18% returns by buying index funds. Thus, paying off your credit card is like getting an 18% return on your money and frees up cash flow – pay your minimum to retirement and emergency fund and use the rest to pay down your credit cards. As for house debt, pay off all other debts that are on depreciating assets. Your car will lose value the longer you own it, just like any other installment loans you may have on furniture or appliances. While student loans won’t depreciate in value, they also won’t increase in value – it’s essentially a loan for an experience, an intangible asset. That’s why homes are the last to be paid off and can also be incredible wealth builders.
Using the Market to Decide to Pay Debt or Retirement
So here’s the Cash Flow Celt method of deciding to pay debt or retirement with that “left over” bit every month. First, I pull up the month’s graph for the Dow, S&P and Nasdaq – this lets me visually gauge the market. Next, I pull of the 30 day and 90 day trailing average for the S&P 500 and compare those against the benchmark I set. If the averages are above my benchmark, I’m probably going to allocate more than half of my “left over” money to debt, rather than retirement; conversely, if the averages are below my benchmark, I’ll likely put more into my IRA than paying off debt. Now I’ll look at the averages themselves. If the 30 is above the 90 day than I know the market has been trending upwards, and if it’s below I know the market has been trending downwards. If the 30 day is way above the 90, I know that there has been an abnormal spike and that means I’ll put more towards debt than retirement, and again, if it’s way below, I know there has been a downward spike and I may put more towards retirement than debt.
Keep this simple. If you’re not a financial whiz kid, no biggy. Find out what the S&P 500 average has been for the last 12 months and make that your benchmark. The base idea is that you want to buy low. If both averages are above the benchmark, the market is in a short-term run on prices. If the 30 and 90 day averages are below your benchmark, you’re in a short-term downturn in prices and you should pay the money towards retirement. Take the control out of your hands. Debt or retirement? Depends on the best place for your money to be. Simple.
In terms of debt the worst kind are credit card and auto loans. However, auto loans are installment payments and are a good type of credit. It’s bad debt because the loan will likely be worth more than the car itself because cars depreciate so quickly. So, when considering which debt to pay off, PAY OFF YOUR CREDIT CARDS! They are bad news bears. After that, pay off your auto loans, student loans, then your mortgage.
When it comes to deciding whether to pay off debt or fund your retirement though, make sure your line item budgets are taken care of first. From there, it’s as simple as spending 15 minutes on Google Finance. Check the averages and make sure you’re buying in a downtrend. At the end of the day, you’re dollar cost averaging and doing it in an effective manner. Efficiency is the Cash Flow Celt mantra. By following these rules you show this Sophie’s Choice isn’t too hard after all.