Managed Money Reporter Newsletter — Issue 174, August 2001


Editors: Carl Spiess & Allan McGlade


Featured Articles



Paying Down your Mortgage vs. Contributing to your RRSP

We all know that owning a home is an extremely important investment and is probably the largest financial obligation we will ever have. We also realize the importance of making annual contributions to RRSPs. This is a common question that we get so we decided to revisit the subject (see MFR, Issue 148). If you have surplus cash, which should you concentrate on first? Indeed, one can find experts to support either argument. Let's examine the alternatives in detail and look at some examples.

Assuming your mortgage has a prepayment option, every dollar you pay on your mortgage comes directly off the principal. This lessens the length of time it will take you to pay off the mortgage and lowers your total interest cost by a significant amount. For example, on a $100,000 mortgage at 7.5%, making prepayments is like getting a tax-free return on an investment of 7.5% each year. Paying down a mortgage also gives a great deal of psychological comfort, which should also be taken into account. Keep in mind that using your paid-off home to help finance retirement can be difficult.

Even if you were to sell your home, purchase a less expensive one and invest the difference, it would not likely be sufficient to finance a 20 or 30 year retirement.

It's becoming more and more important to make contributions to an RRSP each and every year and to invest them wisely so that you can have a financially worry-free retirement. After all, why spend most of your life working and then have to suffer a lower standard of living during what should be some of the most enjoyable and carefree years of your life?

It's important to note that your RRSP contributions are tax-deductible. In investment terms, if you are in a 50% tax bracket, a $1,000 RRSP contribution is equal to $500 in after-tax money to pay down your mortgage. You must also take into account the fact that your contribution compounds tax-free within the RRSP. For a taxpayer in a 50% tax bracket, earning 10% in an RRSP can be like earning a 20% return outside the plan.

Many investors find it difficult, if not impossible, to both reduce your mortgage and add to your RRSP at the same time. Is it best, therefore, to concentrate on just the mortgage or RRSP contributions or to do a little of both?

One solution is to compromise by making your maximum RRSP contribution (or whatever you can manage) and using the resulting tax refund to pay down your mortgage.

Here are a few factors to consider that may help you decide on the best course of action:

  • Your marginal tax rate
  • Your age
  • Where you are in your mortgage amortization schedule.

Your marginal tax rate is important because the higher your tax rate, the greater the up front deduction for the RRSP contribution and the more attractive this option is. Your age should be taken into account because the further you are from retirement, the more valuable your RRSP contributions will be as they have more time to grow. And finally, where you stand in the amortization schedule on your mortgage makes a difference because paying down principal in the early years of your mortgage means that you will save a substantial amount in interest payments in the long run. Conversely, paydowns in the last few years save you relatively little interest. Each household's circumstances differ so it's important to consider all the variables.

Let's examine the four possible combinations of payments that you could make:

  1. Make your RRSP contribution, then invest the tax refund.
  2. Make your RRSP contribution, and then use the tax refund to pay down your mortgage.
  3. Pay down your mortgage, then invest the savings.
  4. Pay down your mortgage, then start making your RRSP contributions

Keep in mind that determining which option is best for you requires a detailed analysis of your particular financial circumstances.

Check out www.mutualfundreporter.com/tools for a link to a helpful calculator to analyze your own personal situation and other useful tools.

 


Here's an example: 

As an example, Dave Taylor has the ability to make a $13,500 RRSP contribution on an annual basis. He also has a $200,000 mortgage he would like to pay off. He's wondering which of the above four combinations would be his best choice.

The following assumptions will be made:

  • 8% return on both his RRSP and Non-RRSP savings
  • Value of the house is $250,000 with an assumed growth rate of 2% per year
  • Interest rate on the mortgage is 7.5% compounded semi-annually
  • Mortgage payments are made monthly with a 25-year amortization
  • $13,500 is paid at the beginning of each year into either the RRSP or mortgage
  • Dave's tax rate is 50% during the savings period and 40% during the payout period (retirement)

Running an analysis based upon the four alternatives noted above, Dave finds the following results at the end of 25 years, when his mortgage is paid off:
 

 
  Net WorthAnnual Payment 
      Alternative 1$1,194,160$85,684 
      Alternative 2$1,285,170$88,585 
      Alternative 3$1,062,580$63,768 
      Alternative 4$1,241,676$86,382 
 

Net Worth = after tax value of built up assets at the end of the accumulation period (25 years)
Annual Payment = after tax retirement income payments for a period of 25 years

For Dave, the best alternative is #2, to make his RRSP contribution of $13,500 and use the tax refund to pay down his mortgage. This will leave him with an annual after tax retirement income of $88,585. Most people would assume alternative #4 would be best, but this would leave Dave with annual after tax retirement income of $86,382. Consider also the situation where an investor loses his job. If he had put the same $13,500 toward his mortgage (alternative #4), he would now find himself in a liquidity crunch. Whereas if he made a $13,500 RRSP contribution while still employed, he would receive a $6,750 refund to put toward his mortgage. If necessary, he could later withdraw funds from the RRSP account for emergency use in the year he was unemployed, and assuming he is earning less that year, he would pay less taxes on the withdrawal. Again, alternative #2, contributing to the RRSP first and using the refund to pay down the mortgage is often the best choice!

 

Team News

We have experienced a few changes within the mutual fund reporter team. Effective July 19, 2001 Nicole Keeler, a long standing Investment Associate within our team has taken maternity leave. We wish her and her growing family all the best.

Also, Sandi Rossi has recently joined our team in an administrative role and has recently completed her CSC (Canadian Securities Course) as well as CPH (Conduct and Practices Handbook Course) in which Sandi received an Award of Excellence for outstanding academic achievement. Her final course grade in the CPH placed her in the top one-percent amongst students who completed the course in the 2000 calendar year. Congratulations Sandi!

Congratulations to Evan Brett and Sirish Sinha, our winners of Quicken Financial Software from our recent survey draw.

If you are interested in receiving our newsletter via e-mail, drop us a line at carl.spiess@scotiawealth.com

 



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