Imagine your retirement. You're probably picturing traveling, relaxing with your family and giving generously toward charitable causes you care about. But if you don't plan carefully, the realistic picture may show you paying off car loans, your mortgage and your children's student loans on a fixed income.
Paying off all your debt before you retire will give you a sense of freedom and comfort. It will also make retirement more affordable and more feasible. When you don't owe anyone money, you can do whatever you want with your extra cash.
"[When we retire,] our earning potential will cease, and we'll start relying on whatever nest egg we built up in our younger years," said Ben Pack, founder of financial knowledge blog YoungMoneyFinance(opens in a new tab), which aims to provide modern, relevant and easy-to-understand information to readers at all stages of life. "Relying on a nest egg is not the time to be in debt. An old proverb states that 'the borrower is a slave to the lender,' and in many ways, it's true."
Even if you're nearing retirement, it's not too late to get serious about paying off your debt. You just need to decide which debts to tackle first. Below, we present three options for paying off debt and becoming debt-free before retirement.
1. The debt snowball
With the debt snowball, you pay off your debts from smallest to largest. You pay as much as you can on the smallest debt while making minimum payments on all your other debts. When the smallest debt is paid in full, you roll what you're paying on that account into your payment on the next smallest balance.
Seeing each debt disappear is a morale booster, and you'll see your first debts disappear quickly. Because people can see their loans decreasing with this method, they're more likely to stick with it than just paying portions of each loan every month. However, because you're not thinking about paying interest with this method, you may end up paying more in the long run than you would if you focused on interest rates.
2. The debt avalanche
With the debt avalanche, you focus on paying off one balance at a time, much like the debt snowball. But there's one major difference. Instead of focusing on the smallest account first, you'll focus on the one with the highest interest rate. This will allow more money to go toward your principal, meaning you'll actually pay down your debt quicker.
Since this way is the fastest, it might seem logical that everyone should pay their debt this way. But if your highest rate balance is big, it may take a long time to pay off the first account. This can be a huge blow psychologically and make you unmotivated to pay off the rest because you won't see any immediate wins.
Before choosing the strategy that works for you, do the math. If the total interest you'll pay with the debt snowball method isn't significantly more than what you'd pay with the debt avalanche method, snowballing your debts may be better.
3. Debt consolidation
Debt consolidation is the process of combining multiple balances into a single, bigger loan, possibly with a new lender. This new loan will come with a new interest rate and a new term length. This can work for or against you, so pay attention to the details.
Combining balances will make payments easier, since you'll only have one payment to keep up with instead of several. And it's possible that you'll be able to negotiate a lower interest rate, which means you won't have to pay as much over time.
But a new loan may give you a longer repayment period, so while it lowers your initial payment, you'll end up paying more over time. Also beware of variable rates, which could dramatically increase your payments over time.
So when is it worth it to consolidate?
Pack shares his advice: "Debt consolidation, in my opinion, should only be used if you're able to overall lower your interest payments, and then use that to get out of debt quicker."
What if becoming debt-free is out of reach?
"I believe that there's 'good debt' and 'bad debt'," Pack said.
"Good debt is debt that's used as a tool for advancement," he said. "Common forms of good debt include getting a mortgage to purchase a house—a great builder of wealth in our society today. Or perhaps debt was utilized through a student loan and used to attend a university or post-graduate school to obtain a degree that advanced your career and ultimately allowed you to earn a lot more than you could without it.
"Bad debt is debt that's used simply because we don't want to wait to obtain something material we want (i.e. not need) but can't afford right now. Common forms of bad debt include credit card debt or other personal loans. When we should be focusing on living within our means, we instead borrow to keep up with the Jones."
Pay off your bad debt first
If the ideal scenario of being debt-free before retirement is out of reach for you, focus on paying off your bad debt while keeping the good debt working for you. If you find that your interest rate on your investments is higher than your interest rate on your mortgage, for example, you may consider keeping your mortgage instead of pulling money out of your investments to pay it off.
The important thing is to estimate your expenses in retirement and subtract that from your expected retirement income to determine whether you'll have the money to continue paying a particular balance once you retire.
Choose the strategy that works for you
If you're currently set to carry debt into your golden years, don't ignore the problem. It can be challenging to live comfortably in retirement while paying down outstanding debt. Considering your retirement timetable, make a plan to pay off as much as you can.
"Take a long, hard, serious look at your finances, and figure out the strategy that's best for you," Pack said. "Make cuts where needed. Perhaps postpone that cruise until next year or eat out a little less."
And once you're out of debt, make sure you don't get back into it. One way to do this is to invest, save and increase retirement contributions. Giving your extra cash a new purpose will keep you from the temptation of spending more and ensure a more comfortable future.
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