It’s a common conundrum facing the average Canadian with limited savings; each year they wrestle with the same nagging "pay RRSP or mortgage" question.
And every year when they ask for professional advice they hear the same answer, as illustrated in this article in the Financial Post: It’s important to save for your future retirement, so use your extra savings to build a retirement nest egg. (In other words,most experts don’t believe paying down your mortgage to be the right answer.)
Debt Payment Back Pedaling
But guess what? The stats are now in from the past 15 years and Wow, did we ever get it wrong! (I say “we” because as an investment advisor for over 20 years I was also guilty in ignoring debt repayment as a priority!)
Using what we know today about mortgage rates, and investment returns over the past 15 years as a guide, the answer to that old question is now much clearer. The correct answer is to forget about your RRSP until after you pay off your mortgage.
Let’s Look At the Math
To make this a simple exercise, let’s make some practical assumptions about the following details regarding the basic finances of an average Canadian investor:
- You’re one half of an average Canadian family earning $40,150 per year. (source: Stats Canada)
- You do not contribute to a company pension plan, so a financially secure retirement is on your shoulders using RRSPs, TFSAs, etc.
- Your earned RRSP contribution room has averaged 18% of your taxable income per year
The Mortgage Impact
Next, let us make a few basic assumptions about your mortgage:
- You took out your mortgage in January 1998.
- You just purchased a home with a mortgage of $190,000 (which is much less than the current average mortgage of $301,000).
- You chose to pay back (amortize) your mortgage over a 25-year period.
- You have always been conservative and used five-year fixed mortgage from your bank, paying an average 6.90% interest rate over 15 years. (1998=6.85%, 2003=6.45%, 2008=7.39%) (Source: Bank of Canada)
Your RRSP Numbers
Finally, let’s make a few basic assumptions about your RRSP savings:
- You’re an average Canadian and have contributed $4,670.00 (Source: Bank of Montreal) annually to your RRSP, and just like the average Canadian, you spend your RRSP income tax refund every year. (After all, like many average investors, you believe you deserve a reward for all of your hard work scrimping and financial discipline – a philosophy that only defeats us in the end, by the way!)
- Each year your personal income tax rate was 35% and you anticipate your retirement tax rate to be 17% (The perfect combo – contribute when your tax rates are high and withdraw when your taxable income is lower.)
- Let’s also assume that you’ve paid less in investment management fees than the average Canadian. Let’s assume your investment costs have been 2.06% each and every year.
- In a best-case scenario, let’s assume you’re not the average Joe investor. Instead, you’re something more akin to an investing god, where for the past 15 years you’ve generated an averaged, before fees, 10.51%, annually on your RRSP investments. (In other words, you were a disciplined Buy-Hold, reinvest all of your dividends disciple of the TSX Total Return Index.)
Note: According to BlackRock, a prominent asset management firm, the average investor earned 2.10% over the past 20 years. So if your RRSP investments averaged less than the 10.51% used in this example, the numbers are even stronger for ignoring the pouring of your savings into an RRSP until after you pay off your mortgage.
Crunching the Numbers
The following chart summarizes the calculations for an average Canadian.
|Problem: Pay Down My Mortgage or Contribute to My RRSP?|
|Lump-sum savings available of average Canadian: $4,670.00|
|Choice #1: Using my savings for an extra annual mortgage payment|
|Mortgage principal outstanding:||$190,000.00|
|Mortgage interest rate:||6.90 per cent|
|Mortgage amortization period:||25 Years|
|Mortgage compounding period:||Semi-annual|
|Mortgage payment frequency:||Monthly|
|Mortgage savings (after-tax):|
|Extra principal payments:||$70,050.00|
|Accumulated value (after-tax):||$161,206.30|
|At this rate the number of years your mortgage will be paid off: – Wow, 10 years early!||15 Years|
|Choice #2: Using my savings for my RRSP contribution|
|Do you spend your RRSP tax refund?||Spend it!|
|Annual rate of return on RRSP investments:||10.51 per cent|
|Estimated annual investment costs:||2.06 per cent|
|Annual rate of return – net of annual costs:||8.45 per cent|
|Investment compounding period:||Annual|
|Estimated pre-retirement income tax rate:||35 per cent|
|Estimated retirement income tax rate:||17 per cent|
|Accumulated RRSP value: (before-tax):||$131,330.24|
|Accumulated RRSP value: (after-tax)||$109,004.10|
|Estimated RRSP investment costs for the 15-year period:||$17,644.73|
|Conclusion: Paying off your mortgage first would generate this total interest and investment costs savings:||$108,801.03|
Note: The calculations for this article use factual historical numbers for mortgages and investments that we have plugged into InvestingForMe’s new Mortgage vs. RRSP Calculator that conveniently calculates which investment makes more cents. To plug in your own personal finance numbers, simply click on this link.
Let’s Look at Those Numbers Again
The numbers in the chart above clearly demonstrate how paying off your mortgage first will save you a lot of money – that’s savings of $108,801.03 in actual, out-of-pocket expenses by ignoring your RRSP until your mortgage was paid off! Or to put it in more tangible terms, that’s $7,253.40 per year or $604.45 per month for 15 years in savings! I don’t know about you, but to me that’s a lot of money to throw away unnecessarily.
Plus, after 15 years, your Accumulated Value (after-tax) of the Mortgage Savings would equal $161,206.30. That’s $52,202.30 more than your Accumulated RRSP Value (after-tax) of $109,004.00.
And yet most of us continue to roll along contributing to our RRSPs first. Why?
Here’s What the Financial Advisors Would Have You Believe
If you’ve been following the standard advice and deposited your extra $4,670.00 of savings into an RRSP and invested it like a god (best case scenario as outlined above),
- After 15 years, you will have accumulated $131,330.24 ($109,004.10 after-tax) in your RRSP.
- You will still have monthly mortgage payments for another 10 years, until your mortgage is finally paid off.
- Over the 25-year mortgage amortization period you will pay $91,156.30 more in mortgage interest and $67,955.88 (25 years of investing your RRSP contributions) in investment fees.
Here’s what the stats from the past 15 years are actually telling us
If you had actually ignored your RRSP and used your extra $4,670.00 in savings to pay down your mortgage each and every year for the past 15 years, here’s what you’d find:
- Your RRSP savings would equal $0.00.
- You would’ve accumulated approximately $94,500 in unused RRSP Contribution Room, (which can be used at anytime and will give you a bigger Tax Refund as your income should be higher).
- You would’ve accumulated $25,500.00 of TFSA Contribution Room.
- Your $190,000 mortgage would now be paid off.
- You would’ve saved $91,156.30 in mortgage interest costs paid to your bank.
- You would’ve saved $17,644.73 in investment costs paid to the investment advisors.
- And best of all, you would simplify your life. Just imagine – 15 years without investment decisions, of not having to out-guess the markets! All that time, worry, and effort expended watching over the value of your investments going up and down – wouldn’t that be nice to have that time back.
Bottom line: paying down your mortgage makes more cents
So, if you decided to pay down your mortgage instead of contributing to an RRSP, your mortgage would be paid off, and you would have saved $108,801.03 in bank and investment costs. This huge savings mean even more possibilities:
- With your mortgage paid off you can contribute your monthly mortgage payments (That’s $15,828.96 per year!) and the extra $4,670 in savings toward your retirement nest egg.
- You can contribute $20,498.96 each year into your RRSP and only claim deductions that absolutely minimize your income taxes payable and maximize your RRSP Tax Refund.
- You can keep contributing to your RRSP until the accumulated $94,500+ of RRSP Contribution Room is fully utilized and the $25,500+ of TFSA Contribution Room is maximized-out. (Note: The “+” indicates contribution room accumulated each year after the mortgage is paid off.)
- Under the same investment assumptions, your $20,498.96 in annual savings would accumulate to $303,381.15 after just 10 years and over a 15-year period would grow to $576,473.94.
So, What Should You Do This Year?
Paying down your mortgage instead of contributing to an RRSP seems to be the answer that makes plain sense (and cents)! There’s really something wonderful about being debt-free, not paying the bank and investment pros$108,801.03 in fees and interest, and gaining a better sense of control that comes with greater financial security. Imagine the tremendous relief in simplifying your financial life:
- Simpler goals – pay off the mortgage
- Simpler decisions – no RRSP investment decisions, meetings or second-guessing earlier investment choices
- Simpler day-to-day living – gone is the stress that comes from watching your RRSP investments go up, down, up, down …
And how do you know whether these conclusions should guide you for the next 15 years? Well, no one knows the future (advisors included), but ask yourself a couple of simple questions:
- What are the chances your RRSP investments will earn you an average annual return of 10.51%, every year, for the next 15 years? Answer: Not too good, Eh!
- What are the chances mortgage interest rates will rise over the next 15 years? Answer: Pretty high! In fact, paying off more of your mortgage while rates are low is probably a good strategy, right?
So, in light of these answers, I would still highly recommend paying off the mortgage first. Oh, and by the way, this concept is by no means a new one. It may be new to our generation, but not to our parents and grandparents who always paid off the mortgage first. They’d never sock money into a savings account while they still owed the bank. To them, that would have been downright stupid!