What makes more sense, paying down debt or saving for retirement?

Especially in today’s climate where many are seeing their retirement savings reduced by the falling stock market, and the debt level of the average American is approaching all time highs, many are faced with a question; should I pay off my bills or put more into savings? There’s a bit of math to really answering this question, and some other considerations, which can affect the answer.

The kind of debt

First let’s consider the kinds of debt we could be talking about. For some a hundred or so thousand in student loans seems like an immense amount of debt. In truth though a twenty thousand in credit card debt could affect your financial situation a lot more dramatically. You can write off interest on student loans, you cannot on credit cards. Further because of the fees and revolving nature of credit cards they can amount to thousands more in costs over a long period of time. With low interest, non-revolving debt it can make a lot of sense to invest as well especially when you factor in the tax advantages of many savings programs, and ability to get ‘free money’ in the form of an employer match, or other tax advantages investing incentives.

The Interest Rate

Much of this also requires a look at the interest rate. Even assuming a rate of return on your savings of as much as 12%, which is what the S&P 500 has averaged since 1926; if you’re paying 25% to your credit card company you’re losing money. In fact if you’re getting 12 percent your money about doubles about every 6 years, while at 25 percent your credit card company is doubling the money they lent you about every 3.6 years, and that’s assuming that you’re not charging it back up!

The kind of savings

Even if you don’t actually have any debt you could still be losing money. Inflation averages 3 percent historically and recently it’s been as high as 4.1, excluding increases in gas and food prices. If your investments are not keeping pace with inflation you’re losing buying power; essentially you’re not making any money, and possibly losing it. This is called inflation risk (as opposed to market risk; when the market goes down, which is what many novice investors tend to think about). So say you’ve got an investment averaging 12 percent, and a 9 percent interest credit card. You could still be in effect losing more than 1 percent of the buying power of your money.

How long until you retire?

Bottom line saving is about the math as much as it is the risks. If you are already nearing retirement you may not have enough time for your savings to begin growing enough to outpace the debt you are paying off. Young investors however may be able to afford more investment risk, ideally for a higher return, and out pace the costs of debt. Either way however debt is eating money every month or that’s extra money you could be saving.

Summary

You have to really look at your projected, as well as historic, rate of return on your investments and compare those to what you’ll be giving to the companies, which hold your debts. There are several on line calculators that can help you accomplish that. If you’re up to your ears in debt and haven’t started saving it’s time to get serious and look at ways to eliminate your debt quickly such as debt consolidation, or debt stacking. To be truly saving you have to be saving more money than you’re losing, and the bigger the difference between the two the faster your savings will grow which is critical to retiring well.

While the Federal Reserve is being tight lipped about whether the US is currently in a recession or will be average folks are certainly feeling a bit different about their wallet. A lot of people are wondering exactly what to do with their retirement savings, or what’s left of it, in the midst of what certainly seems like economic hard times. So what investments are safe in a recession?

What is a Safe Investment?

Some people are of the opinion that with any possibility of loss no investment is safe. Even in that sense though, there’s certainly safer and less safe. Most investors aren’t looking to be billionaires they’re looking to have a normal standard of living in retirement which means making enough money that will continue accumulating throughout retirement to afford that it. That means choosing investments aggressive enough to attain that goal but, especially depending on one’s age, not choosing ones that put your retirement at excessive risk.

Kinds of Risk

To accomplish the above we have to look at the different kinds of risk. Most people worry about what is called market risk; that’s risk that your investment might lose money for a period of time or permanently. While that’s certainly a concern it’s not the only concern, another kind of risk is called inflation risk. That is the risk that no matter what the return on your investment inflation may make the cost of living so much greater that your gains will amount to nothing at all or in fact a lost when compared to the cost of living in retirement,

The True meaning of Diversification

Most investors have heard of the idea of diversification. Essentially don’t put all your eggs in one basket. The problem is a lot of folks don’t really think about what one basket means. A truly diverse investment portfolio should contain both foreign and domestic investments, and those investments should not just be mutual funds but also things like cash, bonds, and potentially even investments such as real estate. Further they should be in diverse industries which are unlikely to experience economic troubles together. The reason behind this is generally if one of these areas is down some of the others are likely up. This reduces the chance for major loses in either category to wipe out one’s savings.

Examples of Safe Investments

There’s a few types on investments which are generally considered safe, even in times of economic strife. Treasury Inflation Protected Securities (TIPS) are issued by the US Treasury, and offer both appreciation as well as protection against inflation. Certificates of Deposit (CDs) are issued by banks but are protected by the FDIC up to 250,000 dollars. Money Market accounts invest in very short term investments, generally ones with very low risk. They are not guaranteed by the Federal Government however they
are usually insured by the SPIC up to 100,000 dollars.

Summary

In general what makes an investment safe is the likely-hood of return on investment. Even with safe investments however one much always diversify. Many regarded municipal bonds as a safe investment before the mortgage crisis. Also, though it’s unlikely, if the US Treasury were to default most of the safe investments backed by it would be in question. For that reason one should always be diverse not only in terms of kinds of risk, but aware of risk in a global market.