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Should I pay down my mortgage or contribute to my Registered Retirement Savings Plan? - a dilemma faced by many people.
What to consider
Paying down the mortgage sooner adds up to more savings in interest payments over the long haul. The advantage of contributing to your retirement savings account is that you can potentially reduce your taxes and build a nest egg. There are advantages to both.
Interest Savings
If you have a mortgage balance to be renewed upon maturity, consider the interest savings based on the renewal rate, not the current rate. Think in terms of pre-tax rates as opposed to the actual mortgage rate.
The mortgage on your principal residence is not tax-deductible, so you are paying it after taxes. If mortgage rates climb to 5 percent in the coming years and you’re in the 35-percent marginal tax bracket, paying off the mortgage faster means you’ll be getting a guaranteed pre-tax rate of return equivalent to 7.69 percent. Making extra mortgage payments reduce the principal amount. So you save not just interest but the tax on that interest because you are paying the mortgage with after-tax dollars.
Even if your RRSP investments make 9 percent, a typical mutual fund charges fees, which could reduce your return by a couple of percentage points. Suddenly that return isn’t looking so good, nor is it a sure thing when compared to the interest rate on your mortgage.
Tax Savings
RRSPs are a good option for people in a high tax bracket now and expect to be in a much lower one when they retire.
Paying off a mortgage quicker has tax benefits as well. An RRSP is a tax deferral. You’re just paying the taxes later when it gets converted into an RRIF, and hopefully when you are at a lower tax bracket. However, there are no tax consequences on selling off your principal residence whatsoever.
Risks
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If you are risk-averse, you may see more value in paying down your mortgage and being debt-free rather than the possibility of making long-term gains on the stock market. Paying down the mortgage is a more conservative approach. And may suit a conservative investor, who may be most comfortable with low-risk investments.
Low-risk investments typically have returns below three percent. It makes sense to pay off a 3% mortgage (closer to 5% since it is pre-taxed money) instead of saving in a GIC paying 2%.
Flexibility
Once funds are deposited in an RRSP, withdrawing them before retirement may incur expensive fees and fines. Paying off a mortgage reduces your fixed monthly costs, leaving you with more money for other expenses. You can then dip into your home’s equity to borrow at preferred rates with a homeowner’s line of credit if you require additional funds. Once that debt is paid off, you can borrow again.
Debt Aversion
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If your debt keeps you up at night, then pay off your mortgage! Everyone has a different degree of tolerance for carrying debt. There are many reasons for why someone may be more willing to carry debt, especially if it debt on appreciating assets. Some people asre uncomfortable with any amount of debt. Neither is right nor wrong.
The Power of Compounding
Your Investments grow at an accelerated rate the sooner you start, through the principle of compounding. Investing $5000 annually from age 25 to 35 (totaling $150,000) at a rate of 7% per year gives you a total return of over $600,000 at age 65. Investing $5000 from the age of 35 to 65 (totaling $150,000) at the same rate of return gives you a total of just over $540,000! It’s not how long but how soon you start investing!
Liquidity
If you lose your job and need funds, you may not qualify for any credit if it is not already put in place while you were working, or there may not be sufficient equity in your home to get a line of credit secured against it.
If you lose your job, dipping into your RRSP would not be a bad idea since you are now in a low tax bracket. And won’t be taxed as much withdrawing it when you have no other sources of income.
If you are financially strapped and have little equity in the home, you cannot choose to sell part of your house to cover short-term needs, whereas you can liquidate part of your investment portfolio.
If you wanted to sell your house, it may take you months before it is sold. Investments are often more liquid than real estate. What are your estate plans?
If you have no dependents, leaving a large paid-off home may not be a goal you have for your estate.
Having your cake and eating it
Get the best of both worlds! I would advise contributing to your RRSPs, especially if you don’t anticipate receiving a pension from your employer and then using the refund as a lump sum payment towards your mortgage. You get the best of both worlds.
Any lump-sum payment made will go towards the principal. Every dollar paid onto principal means one dollar less interest on the entire life of the mortgage.
Many Canadians are house poor, with their house being the only asset they have. Many seniors cannot even afford to pay for the upkeep of their homes. Having liquid assets at retirement when you do have the time to enjoy life is highly appealing.
There are many variables to this dilemma and each case has to be analysed individually. Questions such as how long do you have to retirement? Are you expecting any kind of inheritance? Have you maximised your TFSA?
No matter which way you lean – mortgage or RRSP – you will almost certainly come out ahead in the long run compared with doing nothing to prepare for retirement.
Additional Resources
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Through one on one coaching, webinars, online courses, and public speaking, Jennifer empowers individuals and businesses to achieve the outcomes they desire.
Jennifer Thompson, Compelling 365.