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RRSP season is heading into full swing and many Canadians are going through the annual angst trying to decide if it is better to contribute to their Registered Retirement Savings Plan by the February 29 deadline – and get the tax deduction — or apply the money to help pay down their mortgage.
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The dilemma is particularly vexing these days. The ratio of household debt to disposable annual income is at an all-time high of 153 per cent and Bank of Canada Governor Mark Carney has said he expects it to increase. So it may be no surprise that a recently published poll showed that paying down debt is the top financial priority among Canadians. Managing day-to-day spending and retirement planning took second and third place, respectively.
However, age played a major role in those results. The survey, conducted for CIBC, found that debt repayment was a particular priority for respondents between the ages of 25 and 44, who tend to have more debt and less money to save.
But as we get older, priorities change and it becomes more important to work toward ensuring a comfortable retirement. Respondents between the ages of 45 and 64 put retirement planning at the top of their list.
When it comes to debt, it is often a mortgage that is our largest burden. And unlike our neighbors in the United States, we cannot take a tax deduction for mortgage interest. Thus the rush here to pay down mortgages as quickly as possible. On its face, that plan seems to make financial sense.
For example, on a 6.5 per cent, $100,000 mortgage amortized over 30 years you’re going to pay approximately $126,000 in interest. That makes it tempting to pay down the debt and forsake the RRSP — at least for a while. And, of course, every year you are in debt, real cash is being drained from your savings account.
On the other hand, regular contributions to your RRSP provide tax-deferred compounding and a tax deduction that gets you a refund. Of course that refund helps create a future tax liability because when you retire you will have to pay tax on the withdrawals of your contributions and the money they earned while in the RRSP.
Nevertheless, you can still take advantage of the refund now by putting it in an account where it will compound tax free. That could be either your RRSP or a Tax-Free Savings Account, where you could keep it as a reserve to help pay those later taxes. The refund can also be applied to your mortgage.
When it comes to your mortgage, do the math and consider these three options:
But there or other possibilities: If paying down your mortgage quickly is a priority, consider bi-weekly payments. You will make 26 payments rather than 12. As a result, you’ll make one additional payment each year that is applied to the principal of the loan. You save thousands of dollars in interest costs and shorten your amortization period.
To calculate the benefits, divide your monthly payment by two and multiply it by 26 (or divide the monthly payments by four if you want to make weekly payments, then multiply by 52.) If your monthly mortgage payment is $800, or $9,600 a year, your bimonthly payment would be $400 every two weeks and $10,400 annually. The following chart illustrates how you can save more than $20,000 with bi-weekly payments:
|Payment Frequency||Number of Payments||Interest Costs ($)||Principal Payments ($)|
20 years, 9 months
Accelerated mortgage payments notwithstanding, there is another way to pay down your mortgage while building up your RRSP.
Consider that same 25-year mortgage with the $670-a-month payment, and let’s assume that you:
- Are in a 40 per cent tax bracket;
- Have $500 a month left after paying all your budgeted items and putting money aside for emergencies;
- Have $5,000 to use as a lump-sum contribution to your RRSP or apply to your mortgage; and
- Are trying to decide whether to put the extra money into your RRSP, with 6.5 per cent assumed annual earnings, or apply it to your mortgage.
Using an RRSP vs. mortgage calculator that you can find online, you will discover that the $5,000 lump sum and the extra $550 a month payment would produce these results:
- The amount of the mortgage and interest would drop by $79,436.42 and your amortization period would drop to 8.83 years.
- Investing in the RRSP would generate the same amount of money over the same period plus tax savings of about $23,200.
- Using the tax savings to pay down your mortgage would lower the amount of the home loan with interest by $60,143.12 and your mortgage amortization period would decline to about 14.25 years.
In this specific scenario, you would get the best of both worlds: On top of the after-tax value of your RRSP, you would save in mortgage interest costs and reduce the term of the loan.
The decision between paying down a mortgage and investing in an RRSP is very personal and should be made with the help of your accountant, taking into consideration all of your other financial needs and goals.
1 Source: Mortgage Wise Booklet, Canadian Bankers Association through Bennett Gold Chartered Accountants LLP