Daily Gains Letter

How to Save for Retirement Even When You’re Buried in Debt

By for Daily Gains Letter | Feb 14, 2013

DL_Feb_14_2013_JohnIt’s hard for some people to think of saving for retirement when they’re sinking in debt.

During the third quarter of 2012, total consumer debt stood at $11.3 trillion. Of the roughly 47% of American households with credit card debt, the average balance is more than $15,400. Average mortgage debt is $149,782, and average student loan debt sits at $34,703. (Source: “Quarterly Report on Household Debt and Credit,” New York Federal Reserve web site, November 2012, last accessed February 13, 2013.)

With an unemployment rate hovering near eight percent, a weak U.S. dollar, and anemic growth projected for the near future, U.S. households are trying to avoid further debt—especially high-interest debt, like credit cards. While less debt is good, a downturn in consumer spending also has the reverse effect of limiting the speed of economic recovery.

The need, or reluctance, to use credit cards for purchases also points to the fact that Americans have less money in their pockets, which does not bode well for a consumer-driven economy.

It also means that Americans have less money to set aside for retirement or a rainy day.

According to a study by the Employee Benefit Research Institute, just 14% of Americans are “very confident” they will have enough money to live comfortably when they retire; 23% say they are “not at all” confident. Many workers also noted that they have virtually no savings or investments. (Source: “The 2012 Retirement Confidence Survey; Job Insecurity, Debt Weight on Retirement Confidence, Savings,” Employee Benefit Research Institute web site, March 2012, last accessed February 13, 2013.)

Saving for retirement means investing in stocks and bonds; unfortunately, with high levels of debt, it makes more sense to pay all that down before looking to save for the future.

Or does it?

While debt can be a major obstacle for saving and investing—it’s not insurmountable. It’s all about balancing the numbers.

For example, if you have a line of credit debt with an interest rate of eight percent, the money you set aside for investing needs to make the same interest just to break even—more than eight percent for a profitable venture. With retirement security at risk, in some cases, it’s worth paying down debt and investing in high-yield investments.

Not All Debt Is Created Equal

First, it’s important to understand what kind of debt you might have.

For high-interest debt, credit card debt or anything with an interest rate above 10% could fit into this category. Finding a credit card with an interest rate above 20% isn’t uncommon. Investing in your future is important, but not as important as paying down high-interest debt first.

On the other hand, low-interest debt is the kind of debt that’s usually described as being “prime plus one” or “prime minus one.” Car loans or a line of credit are usually low-interest debts. Adding investments to your portfolio that can beat five percent interest are a lot easier than finding ones that need to return 20% or more.

Tax-deductible debt includes mortgages, student loans, business loans, and investing loans. For this kind of debt, interest paid is returned in the form of tax deductions.

If you are saddled with high-interest debt, then tackle that first. However, if you have low-interest debt and or tax-deductible debt, it’s easier to pay that down while building a strong investment portfolio.

Debt Investment Strategies

Conventional investing wisdom suggests that individuals should hold a well-diversified portfolio of stocks, bonds, and cash that grows proportionally as you age.

The old adage for allocating funds between stocks and bonds holds that you should keep a percentage of stocks equal to 100 minus your age. If you are 35, put 65% in stocks and 35% in bonds. If you are 60, put 40% in stocks and 60% in bonds.

This methodology doesn’t hold true for those with significant debt loads; but it does involve balancing low-risk, low-yield investments with high-risk, high-yield investments.

Instead of making a portfolio adjusted according to age and risk tolerance, think of loan payments as replacing low-risk investments, like bonds, Treasuries, and certificates of deposit (CDs). By doing this, you will realize “returns” by paying down your debt and minimizing interest charges. These savings will clearly outstrip the 1.9% returns you would get by purchasing a 10-year U.S. Treasury note or bond.

The rest of your portfolio (no matter how small) can be built on high-risk/high-return investments, like stocks. If you want to look for investments that provide income and growth, look for fundamentally sound stocks that provide annual dividends. Some excellent stocks to look at could be AT&T Inc. (NYSE/T), Johnson & Johnson (NYSE/JNJ), Carriage Services, Inc. (NYSE/CSV), and GlaxoSmithKline plc (NYSE/GSK), which all have long histories of providing both capital appreciation and income.

You don’t have to be rich to invest in the stock market or consider dividend paying stocks. There are a large number of excellent stocks trading under $10.00 with a long track record of providing strong dividend yields.

While the bulk of your investment income will be diverted toward loan payments, it’s important to set some aside for stocks. Paying down low-interest debt saves on interest while investing in stocks can create long-term income.

Why invest in the stock market if you don’t have much to invest with? Simple—it’s all about compounding. Paying off debt diverts time and money—the two ingredients for creating wealth—away from retirement planning. By investing even a little, your portfolio has time to compound. Initial investments may be small, but thanks to compounding, the payoff will be greater than if you had waited to invest later in life.

Even though you may have debt, it is still important to consider long-term investments, like stocks. Regardless of the amount, compounding can make a significant difference, even on small sums of money, over a long period of time. Plus, it can give you a leg up once your debt is paid off and you are ready to invest in your retirement more aggressively.

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