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Do I pay off debt or save money for retirement? 5 questions to ask yourself

by Jim Sloan

It's an age old question. Do you pay off debt or set aside the money for retirement?

You probably already know that paying off your debt with high interest rates is a great idea. But you also probably know that a disciplined approach to saving for retirement is important. So what do you do if you only have enough money to only pick one or the other?

Some people will say that this is a simple math equation: you go with the option that saves you the most money according to a calculator. But it isn't always as easy as that to calculate or to quantify the intangible benefits associated with each of these (for example the relief it gives you to pay off debt early, or the financial peace of mind when it comes to your retirement).

Before you make the choice between savings and paying debt, ask yourself these five questions to see what the best option for you is:

1. What exactly is my debt situation?

Not all debt is bad. If you have a mortgage at 5 percent or lower you have a great rate, a tax deduction and stand a decent chance of seeing inflation and real estate appreciation lessen the impact of your long-term mortgage. This is debt you can keep.

On the other hand, high-interest credit cards and other variable rate loans can be deadly to your financial health. Even if you think you have a handle on your finances, you should do a quick rundown of all your variable rate debt. This includes student loans, lines of credit and even personal loans you may have with family and friends. Next dig down into the details. Are they fixed or variable? Are they indexed to the prime rate or a Treasury index? And most importantly, how quickly can you pay off your high interest debt if you skip or reduce retirement contributions for a few months?

2. Do I trust myself?

It is an easy question, but remember some people have to set their alarm clock ahead ten minutes ahead just to fool themselves into waking up every morning. The same principle can apply to retirement saving. Skipping a few contributions to pay off debt and then trusting yourself to make those important contributions down the road may be asking too much. And do you trust yourself to invest a future windfall or bonus into retirement savings? Or will you spend it as fast it comes?

If your worry about your self-discipline, then increasing your monthly retirement contributions becomes more important. This may mean that you may carry a little more debt than your neighbor, but you made the right decision for your situation.

The flip side is also true. If you can trust yourself to invest in retirement savings responsibly, you can be more aggressive paying off debt by forestalling or reducing retirement contributions for a short time. If you go down this path, it is preferable that you wrap up your debt-paying mission in six months or less and then go back to making your regular retirement contributions.

3. How far behind am I?

A CNBC report that aired in 2010 stated that Americans are $6.6 trillion behind in their retirement savings. Does that number include you? It is easy to find useful retirement calculators online. You enter a few numbers and voila, you get an exact answer to how far behind you are in reaching your retirement savings goal.

These retirement models are highly variable and should not cause you undue worry, but at the core their basic principle is sound. The simple fact is that investing early allows the power of compounding returns to accelerate your retirement savings over time. Run the numbers to see where you stand. It may give you an idea of how much you can afford to shave off your contributions to pay off your high interest debt.

4. Is my employer matching?

An important feature of retirement savings is the matching programs where companies match their employee's retirement contributions. This is better than free money. It is free money that compounds year after year and can make retirement possible earlier. If you are thinking of reducing your monthly retirement contribution to pay off debt, even for a short time, make sure you stay above the minimum amount required to keep receiving your employers matching portion.

5. What are my sources of retirement income?

Everyone seems to worry about retirement. A recent poll of Americans approaching 65 conducted by the AARP showed that even people approaching 65 are still worrying about their retirement savings lasting. The poll confirmed that a higher percentage of senior citizens are working past retirement age today, either for economic reasons or just to stay busy. Either way this is extra income that can change the analysis for paying off debt.

Income at retirement can include social security, pensions, annuities or even reverse mortgage payments on top of retirement distributions and paychecks for those working part-time. It is a good idea to project your retirement income and how well it is protected from inflation.

If your retirement income looks likely to fall short of what you think will need, you should focus on making extra contributions. It doesn't mean you can't pay off debt, but you can't afford to skip monthly contributions as easily as someone who has a very reliable source of retirement income.

Disclaimer:This content is not provided or commissioned by American Express. Opinions expressed here are author's alone, not those of American Express, and have not been reviewed, approved or otherwise endorsed by American Express. This site may be compensated through American Express Affiliate Program.

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