One of the bigger questions in Mortgages and Financial Planning that we hear all the time is, ‘Do I buy RRSPs or pay off my mortgage faster’. For everyone there will be a pretty clear answer to this question, but this does not mean that the answer will be the same for everyone.
The article will help guide you towards the best answer for your unique situation.
In doing so we will look at the ‘rrsp or mortgage payoff’ question from a few perspectives, including (1) how close to the start of the mortgage you are, (2) what stage of life you’re at (age) and (3) what other investment options are available to you.
How close to the Start of the Mortgage are you?
During the first few years of a mortgage, a much greater portion of each monthly or bi weekly mortgage payment goes towards interest.
Usually over 50% of each payment goes towards interest during the first term of a mortgage, and then as the mortgage amount owed (called the principal amount) is paid down over time, less and less portion of each payment goes towards interest. There is a cumulative, or perpetual effect of paying off the mortgage, where the more principal is paid, the easier it becomes to keep paying more off on each regular payment.
So towards the end of the mortgage, over 90% of each payment is going towards repaying the mortgage principle, while only 10%, and eventually less, is going towards interest.
On the other hand, when buying an RRSP, Canadians can receive a big tax break when the income tax return is filed. More specifically, if an individual is in a 30% marginal tax bracket, they will receive upto 30% back on their RRSP invested money (the tax that CRA collected during the year) at tax time. For example, $300 in tax refunds for every $1000 of RRSPs purchased if the tax rate was 30%.
If this tax refund is then re invested into more RRSPs, the effects over time given compound growth of the investment can earn the investor excellent returns.
Interestingly, when a mortgage is paid back faster, we are lessening the negative effect of compound interest working against us, and when investing in RRSPs, we are improving the effect of compound interest working for us.
So given this deeper understanding of the benefits of each option, we can find a very simple and reasonable answer to the RRSP Vs Faster Mortgage payback question:
If you are paying more in mortgage interest as a percentage of the mortgage payment, than you are receiving as a tax return from RRSPs, then it makes sense to repay the mortgage faster.
For example if 40% of each mortgage payment is going towards mortgage interest, and your tax return from buying RRSPs is 35% – then it would likely make sense to pay back the mortgage faster in this situation.
The percentage of interest on each mortgage payment can be seen in your mortgage amortization table, which is available through leading mortgage brokers Kitchener Waterloo. Your marginal tax rate can be found here.
Since the interest portion as a percentage of each mortgage payment made is less than the instant return on RRSP (your marginal tax rate), some more consideration could be given to purchasing RRSPs over additional mortgage payments.
The argument can be made that buying RRSPs (or other investments) can lead to higher returns on investment over time, and in some cases this could definitely be true, as will be discussed in the final section of this article. But other factors come into play such as paying income taxes on the cashed in RRSPs (at retirement), inflation of our dollar that erodes investment returns, and investment fees that could easily drop a 8% yearly return on investment to less than 4% actual/ real return on investment.
If we look at the risk involved with that RRSP return and compare it to the guaranteed after tax savings from a faster mortgage repayment, then it really does become a close call.
Using the percentage of interest paid with each mortgage Vs RRSP income tax return amount gives us a simple and reliable answer that will more than likely get most individuals ahead financially. But this is only factor to consider.
Life Stage/ Age
A younger individual in their 20s, 30s or 40s will likely differ in their approach to mortgage repayment, than someone who is in their 50s or 60s.
As noted the the above section, it can definitely make sense to focus on paying off the mortgage faster when the amount of interest paid as a portion of each payment is higher. Typically this is the case for younger to middle age homeowners.
A big point to consider is that younger home owners are still well away from retirement, whereas individuals in their later 50s and 60s need to seriously consider how they will be supporting themselves in retirement – weather it be through savings, part time work, or both.
In most cases, it makes sense for those in the who are drawing closer to retirement start saving more even if there is still a considerable amount of mortgage left to be paid.
Why, more specifically does this make sense?
If there is not going to be several million in savings available, or other substantial pensions to draw on (more on pensions this in the next section) during retirement, then likely the taxable income will be considerably lower during retirement, when the RRSPs are being cased, than it was during the working years.
The significance of this is that there is a bigger benefit received from buying RRSPs during the working years when the income tax rates are higher, and since income may be lower in retirement, the tax paid back to the government on cashing in the RRSPs will yield a good net return to the investor/retiree.
So when seen in contrast to paying off the mortgage, faster, this net benefit of lower taxable income tips the scales in favour of investing in RRSPs – even if there is substantial mortgage remaining in the 50s and 60s.
In short, waiting to invest for retirement has the effect of placing a greater value on the RRSP dollars saved for retirement, rather than paying down the mortgage.
Downsizing the home
The ideal situation entering into retirement is to be mortgage free, if not very close to mortgage freedom. This can easily free up hundreds if not thousands of dollars per month that can be used for enjoying life. The house should be there as a tool to help you retire in freedom and in comfort, not as a burden that forces discomfort in the form of relatively high payments or more years worked.
In many cases the kids have moved on, and the larger space is no longer required. In other cases it can simply become a matter of practicality that the home be sold to raise funds to pay off the mortgage.
The great thing about selling a home is that the return or ‘profits’ generated from the sale are completely tax free. So for example, if a house was purchased for $400,000 and 10 years later it is now worth $550,000, then in this example, the $150,000 return on this house would be received tax free by the homeowner.
This return on the sale of the house can be used to repay the mortgage, and then a less expensive house can be bought that is completely mortgage free.
So even if savings and income available in retirement are not substantial, at least there is no hefty mortgage payment in the picture causing financial strain.
Other individuals with bigger pensions and more savings may work hard to get the house paid off before retirement and may wish to remain in their home during retirement. But for many people, downsizing the house can be an excellent option instead straining to become mortgage free when savings may not be high enough to retire in comfort.
There are some special cases where it almost never makes sense to repay the mortgage faster, no matter what percentage of the payment goes towards mortgage interest, or how close to retirement you are.
The most common of these cases is where the employer has some sort of investment matching arrangement. This could be in the form of a pension, or it could be an RRSP plan set up through the employer that matches a percentage of the investment income. In other cases, there are some large pension funds that don’t allow matching, but are able to achieve unusually high returns net of investment fees. OMERS pension is one such example in Ontario.
There’s no money like free money, and in cases where the employer has an excellent dollar for dollar contribution setup it can be very hard to justify paying off the mortgage faster. These special arrangements should be maxed out before additional pre payments are made on the mortgage.
For many of us though, it is all up to us to save and when faced with the decision between RRSP (or TSFA) savings and paying the mortgage back faster, the amount of home left to be repaid (or percentage of interest on the monthly payment), and point in the financial planning lifecycle (age) can help guide you in the right direction to get the best use out of your money.