We Do the Math: Save for Retirement or Pay Off Credit Card Debt?

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Should you save for retirement or pay off credit card debt? If you're carrying a card balance, you may be wrestling with whether to put all your resources into attacking the debt, or start building your retirement nest egg while you slowly pay off debt.

Which one will give you a better net worth? There's no simple answer. For some people the situation may warrant clearing credit card debt first; for others, it's better to start investing right away. To figure out which scenario is better in a given situation, we'll need to do some math. Don't worry, we'll show you how to do it in a few easy steps.

Step 1: Gather important numbers about your debt and your retirement plan

First, look through your credit card statements and accompanying information to pull up the following numbers:

• Credit card debt. You'll find this on the front of your credit card statement.
   
• Credit card interest rate, or APR (Annual Percentage Rate). You'll find this further down on your statement, in a section labeled "Interest Charged" or something similar.
   
• Minimum payment. You'll find this in your card's terms and conditions, under a discussion about how minimum payments are calculated. It will probably be a percentage, but there may also be a flat sum.

Next, consider any retirement plan you are enrolled in or have available. What is the average annual return? You can identify past returns by reviewing your retirement account statements. For example, your 401(k) plan account may list your annual return. Note that past returns don't guarantee or predict future returns, but we'll use the average annual return as a proxy for future returns in this case, knowing that if our portfolio takes a long-term downward turn, our calculations will change.

Finally, how much extra do you have in your monthly budget that you could put toward credit card payments, retirement investments, or both?

Follow along as we consider a hypothetical debt situation and retirement opportunity. Let's say there's $500 in our monthly budget, which equals $6,000 annually ($500 x 12 months = $6,000) to put toward debt or retirement.

Currently, the balance on our credit card is $5,000. Our APR is 22%. Our minimum monthly payment is 3% of our outstanding balance or $25, whichever is greater.

Our employer offers a 401(k) plan. For the sake of keeping this illustration simple, we'll say our employer doesn't match employee contributions and we choose to make taxable contributions with a Roth designated account within the 401(k).

In reality, you might choose instead to make tax-deductible contributions to a traditional retirement account. With a Roth 401(k) there are no immediate tax benefits, which makes our calculations simpler and therefore better suited for this purpose.

We'll say the default investment in our 401(k) is a target-date mutual fund with an average annual return of 6.3% since its inception. We know that future performance is unpredictable. But to run the numbers for the retirement vs. debt decision, we'll apply an annual return of 6% to our retirement account.

We'll look at the retirement account and credit card balance after five years to compare the two choices: 1) making minimum payments on our card balance so we can start investing right away, or 2) putting all our extra money toward our credit card debt before we consider retirement investing.

In both scenarios, we'll assume that we won't make additional charges on our credit card. In addition, we'll contribute to our retirement account when we have money available to invest.

Step 2: Calculate net worth if you prioritize retirement savings over paying off credit card debt quickly

In this scenario, we'll see what happens if we only make minimum payments on our credit card so that we can get started investing for retirement right away. Your credit card statement should state very clearly how long it will take to pay off your balance if you make minimum payments.

You can also find an online calculator to help you with these calculations. Here's the information we'll enter for our example (you can put in your own numbers from your real-life situation):

• Current credit card balance: $5,000
   
• Annual percentage rate: 22%
   
• Proposed additional monthly payment: $0
   
• Minimum payment percentage: 3%
   
• Minimum payment amount: $25
   
• Skip December payment when offered? No

Results indicate that we'll carry this debt for more than 17 years (205 months) and pay more than $7,000 in interest during this time. Click the button that says "Detailed Results" to see a breakdown of the payments. Make sure that under the Assumptions tab, you've asked for a monthly table display.

In the first month, our payment is $150 and this amount slowly diminishes until we're paying the minimum amount of $25 for the last several years.

Since we're making minimum payments on the credit card, we'll be able to put $350 of our total available $500 toward retirement in the first month ($500 - $150 = $350). The second month and subsequent months, we'll be able to increase the amount we invest, as our credit card balance dwindles. Every month we also earn some interest (6%/12 months), so our retirement account balance grows in that way, too.

After five years (60 months), our credit card balance will be trimmed to less than $2,500.

At the end of five years, our retirement account grows to just over $27,300. Considering our debt and retirement balances, our net worth is $24,800 ($27,300 in assets and $2,500 in liabilities). Note that investment returns are not guaranteed; the 6% rate is for illustration purposes only.

You can download the spreadsheet with these calculations.

Step 3: Calculate net worth if you pay off credit card debt completely before investing for retirement

In this scenario, we'll apply all of our extra income to credit card debt first. When the debt is paid in full, we'll begin to contribute to the retirement account.

We enter this information to learn how quickly we'll pay off the debt with $500 per month (again, enter your own information to get personalized results):

• Current credit card balance: $5,000
   
• Annual percentage rate: 22%
   
• Minimum payment percentage: 0%
   
• Minimum payment amount: $0
   
• Proposed additional monthly payment: $500
   
• Skip December payment when offered? No

To keep the credit card payment at $500 per month (and pay off credit card debt first), we'll enter the minimum payment percentage as 0% and the minimum payment amount as $0 — even though the actual terms of the credit card agreement will most likely specify a percentage of 2% or more and a minimum payment of $10 or more. When we view the results, we find that the payoff happens in 12 months. We'll make 11 payments of $500 and one payment of $74.

After we finish paying off the credit card debt, we can begin investing. We'll invest $426 in the twelfth month ($500–$74) and $500 in subsequent months. Consider using a Future Value calculator, to determine how much your retirement account will be worth at the end of five years.

Here's the information we entered into the Future Value calculator:

• Number of periods: 48. (We'll invest for four years, or 48 months.)
   
• Start amount: $426. (We'll start with the first month's contribution as the balance in our account.)
   
• Interest rate: 0.5% (6% annual rate divided by 12 months).
   
• Periodic deposit: $500.
   
• Deposit made at the beginning or end of the period: End.

If we earn 6% annually on our investments, our retirement account grows to $27,590 in five years. In addition, our credit card debt is paid off. Our net worth is $27,590 — that's $2,790 more than if we had prioritized retirement savings first and stuck with only paying the minimum on our credit card debt each month.

What else to consider

These calculations are a starting place. Your situation may be similar to this scenario, but it might not be. For instance, if your APR is considerably lower and your retirement returns higher than in the scenarios above, you may very well find that you're better off investing in the market while reducing your credit card debt slowly. Changes in one or several of these factors could alter results:

• Larger or smaller credit card balances;
   
• Higher or lower credit card APRs;
   
• Better or worse investment performance;
   
• Availability of a company match on your 401(k);
   
• Administrative fees associated with your 401(k);
   
• Choosing to invest in a traditional 401(k).

If you opt for a traditional 401(k), your contributions come out of your pretax income, thereby reducing your taxable income, which could result in a lower tax liability and a higher tax refund. A tax refund could be applied to your credit card balance, allowing you to more easily pay off debt while also saving for retirement.

To calculate the immediate tax benefit of saving within a traditional 401(k) account, multiply the contribution amount by your marginal tax rate. In addition, you could be eligible for a saver's credit, which further increases the benefit of retirement savings.

How to get started with either scenario

Whatever path you choose, you may need help taking first steps. Consider these ways to get started:

Debt payoff

• Consider transferring or consolidating your balances on a 0% balance transfer card.
   
• Consider a no-spend week or month in which you don't spend on anything except essentials.
   
• Apply cash gifts from family to credit card balances.
   
• Work a part-time job to pay down balances.
   
• Find ways to spend less on everyday expenditures and apply savings to debt payoff.

Retirement saving

• Consider enrolling in your employer's retirement plan, if offered. You may have the opportunity to contribute to a 401(k) or 403(b) account, for example.
   
• Set up an IRA with a brokerage account or robo-adviser.
   
• Start an SEP-IRA if you have self-employment income.

When considering your choices, keep in mind that credit card interest rates are relatively fixed, whereas investment returns tend to be much more variable. The main instances in which credit card rates fluctuate these days are when the Federal Reserve raises the federal funds rate, or when you make late payments and are charged a penalty interest rate.

The point is, if your card's APR is 22%, you could be certain to save at least 22% of your balance by paying off credit card interest early. In contrast, the precise benefit of early investing is less certain.

Should you save for retirement or pay off credit card debt? Doing the math can help you make a decision.

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