Should I Pay off Debt Early or Save for Retirement?

How do you choose what goal should be at the top of your priority list? This question becomes especially tricky when you try to decide which to do first — pay off existing debt or save for retirement? In fact, this is one of the most common questions people ask financial advisors.

When you want to do both of these things, the "right" answer isn't always easy to find. Here's how to solve this puzzle so you can decide what belongs at the top of your list.

Financially speaking, prioritize the goal with the higher rate of return

If you want the short and simple answer to this question, just do the math. Jean Chatzky says you need to look at the average rate of return1 on paying off your debt versus the average rate of return on savings for retirement. Whatever rate of return is higher — that's the goal you need to prioritize.

To find the rate of return for paying off your debt, just look at the interest rate you're currently paying. That's how much you'll save each year by not carrying that extra debt. For example, if you're currently paying 12% interest, then that will be your rate of return by paying off that debt early.

As for the actual rate of return on your retirement savings, you won't know this for sure until you actually use it at some point in the future. However, to make the best financial plan for yourself, a reasonable educated estimate is that your nest egg will return 7%. That's been the average return of the S&P 5002 since the 1950s, although it's important to note your investments may perform differently depending on your individual portfolio and how you manage it.

Let's look at a couple of examples:

• Say you have a loan with a 3% interest rate. You assume you can get a 7% rate of return by contributing to your retirement savings if you invest that money. In this case, you should prioritize saving for retirement because that option provides you with a better return in the long run.
  
  
• However, let's say you carry a credit card balance with an interest rate of 15%. This is more than double what you can reasonably expect to earn by saving for retirement. So the best decision would be to pay down your debt faster.

If you feel comfortable doing the math — and then doing what the math suggests — determining the best option can be quite straightforward. But we don't live our lives in spreadsheets, and the optimal financial choice might not be the best choice for you depending on other factors in your life.