Prioritize debt reduction over saving for retirement

According to this Nerd Wallet article most financial advisors say it is better to contribute some money to your company’s 401(k) plan.   This is bad advice for most young adults who are entering the workforce with a substantial amount of student debt.

Most students with substantial student debt should reduce or forego retirement savings until their debt levels become manageable.  Students entering the workforce with substantial debt could reasonably forego saving for retirement for the first three years of their career. Potential advantages of pursuing a debt reduction strategy and the creation of an emergency fund over saving for retirement include:

  • Reduced lifetime student loan interest payments
  • Improved credit rating and reduced lifetime borrowing costs
  • Reduced likelihood of raiding retirement plan and incurring penalties and tax
  • Increased house equity and reduced stress associated with debt

Discussion of advantages of rapid student loan reduction at the expense of saving for retirement:

  • The decision to initially forego saving for retirement and earmark all available funds towards repayment of student debt leads to a substantial reduction in lifetime payments on student debt.  Two examples of the magnitude of the reduction in lifetime student loan payments are presented below.
  • A student borrower starting her career with $30,000 in undergraduate loans could take out a 20-year student loan leading to a monthly payment of $198.82 and lifetime loan payments of $47,716.   Alternatively, this student borrower could forego contributions to her 401(k) plan, increase student loan payments by $565.4 per month and pay off her student loan in 61 months.   The new total student loan repayments are $33,837, a total savings of $13,879. 
  • A second borrower with three student loans — a $35,000 undergraduate loan at 5.05%, a $40,000 graduate loan at 6.66% and a $25,000 private student loan at 10.00% — choosing the standard 20-year maturity on all loans has a monthly payment of $775 and realizes total lifetime payments of $200,633. The modification of the private loan to a five-year term initially increases the monthly student loan to $1,065.  The total lifetime student loan debt payments for the person who repaid her private student loan in 5 years instead of 20 years and earmarks the reduced loan payment to further loan reduction is $146,271.  This is a total lifetime savings of $54,362. 
  • The student borrower who rapidly reduces or eliminates all student debt can increase savings for retirement once the monthly student debt payment falls or is eliminated. Furthermore, the rapid elimination of the high-interest-rate private student loan could facilitate refinancing of the remaining student debt at favorable terms.
  • The failure to maintain a good credit rating will lead to higher borrowing costs on all consumer loans and on mortgages in addition to higher lifetime student loan payments.  
  • Assumptions on the impact of credit quality on interest rates were obtained for credit cards from WalletHub, for car loans from  Nerd Wallet, for private student loans from Investopedia, and for mortgages from CNBC.  The differential between interest rates on people with good and bad were 9.8 points for credit card debt, 7.0 points car loans, 10.0 points for private student loans, and 1.6 points for mortgage debt.  The monthly cost of bad credit depends on the interest rate differential, the likely loan amount, and the maturity of the loan. The analysis presented here assumes a likely loan balance of $10,000 for credit cards, $15,000 for a car loan, $20,000 for a private student loan, and $300,000 for a mortgage.  The analysis also assumes the borrower only paid interest on credit card debt and loan maturities were 60 months for car loans, 240 months for private student loans, and 360 months for mortgages.  Based on these assumptions, the monthly cost of bad credit was $82 for credit cards, $49 for car loans, $124 for private student loans, and $277 for mortgages. A person who fails to eliminate debt could end up with higher borrowing costs for their entire lifetime.
  • Increasingly, young adults are tapping 401(k) funds prior to retirement to meet current needs.  Often individuals who raid their 401(k) plan prior to retirement incur additional income tax and financial penalties.  A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan. A study by the Employment Benefit Research Institute (EBRI) reveals that 40 percent of terminated participants elect to prematurely withdraw 15 percent of plan assets. A poll of the Boston Research Group found 22 percent of people leaving their job cashed out their 401(k) plan intending to spend the funds.  New entrants to the workforce who prioritize the reduction of student debt over saving for retirement will be less like to raid their retirement plan and incur tax and financial penalties. 
  • Many people who fail to prioritize debt payments struggle with debt burdens for a lifetime and fail to realize a secure financial future. A CNBC portrayal of the financial status of millennials found many adults near the age of 40 were highly leveraged struggling to pay down student debt, using innovative ways to obtain a down payment on a home and barely able to meet monthly mortgage payments.  A 2019 Congressional Research Service Report found the percent of elderly with debt rose from 38% in 1989 to 61% in 2021.   The Urban Institute reported the percent of people 65 and over with a mortgage rose from 21% in 1989 to 41% in 2019.  A 2017 report by the Consumer Finance Protection Board found that the number of seniors with student debt increased from 700,000 to 2.8 million over the decade.  Many of these problems and financial stresses could have been avoided if the student borrower entering the workforce had initially focused on debt reduction and the creation of an emergency fund rather than saving for retirement.

These problems will worsen if borrowers don’t start focusing on debt reduction over saving for retirement because many in the new cohort of borrowers are starting their careers with higher debt levels.

Concluding Thoughts:  Many financial advisors stress saving for retirement over debt reduction.  Fidelity, a leading investment firm, says young adults should attempt to have 401(k) wealth equal to their annual income at age 30.  Workers without debt and with adequate liquidity for job-related expenses can and should contribute.   Their returns will compound overtime and they will have a head start on retirement.

Young adults attempting to balance the accumulation of some retirement saving with the quick retirement of student debt should use Roth IRAs or Roth 401(k) plans because the initial contribution to a Roth retirement account can be disbursed without penalty or tax. 

The Fidelity savings objective is unrealistic for most student borrowers with debt. The current cohort of people entering the workforce has more debt than any previous cohort.  Average student debt for college graduates in 2019 was 26 percent higher in 2019 than 2009.  The decision by a new worker with student debt to go full speed ahead on retirement savings instead of creating an emergency fund and rapidly retire student debt can and often does lead to disaster.  The young adult choosing retirement saving over debt reduction pays more on debt servicing, invariably falls behind on other bills, pays higher costs on all future loans, and often raids their retirement plan paying taxes and penalties.   

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