At age 52, Jasmine is one happy entrepreneur. Last year, she started a home business and is earning an extra $500 a month. Now that she’s making more money, she wants a new plan for her future. She likes the idea of paying back her mortgage faster. She also knows she needs to build savings for her retirement. Should she use this extra $500 to pay off the mortgage earlier, or to build her RRSP?
- Jasmine’s mortgage is $75,000 and she’s about to renew for the final 10 years at 5.5%. The monthly payment is about $812.
- If Jasmine adds $500 a month, the mortgage payment will be $1,312 and the loan will be paid off early. The interest saved would equal a risk-free, tax-free return equal to the mortgage rate: 5.5%. After the mortgage ends, Jasmine could put $1,312 into her RRSP each month.
- Can Jasmine count on her RRSP to earn more than 5.5%? Normally, risk-free investments like GICs pay less than banks charge on mortgages. Jasmine thinks she can earn 5.5%. (To keep it simple, let’s ignore the tax break on RRSP contributions. Often, tax at withdrawal recovers the value of the upfront tax break. The RRSP’s real value is the tax-sheltered compound growth.)
- Either way, Jasmine pays out $1,312 each month. Either way, her house will be paid off within 10 years.
|Accelerate mortgage||Accelerate RRSP|
|Monthly mortgage payment||$1,311.65||$811.65|
|Mortgage paid off in||5 years and 7 months||10 years and 0 months|
|Total mortgage payments||$87,006||$97,398|
|Total RRSP contributions||$70,392||$60,000|
|Total paid for mortgage and RRSP||$157,398||$157,398|
|RRSP value at end of year 10||$79,713||$79,535|
There’s almost no difference because the mortgage and RRSP rates were both 5.5%. The small difference is only because a standard mortgage compounds semi-annually while we compounded the RRSP annually. With the same compounding, there would be no difference.
So, the key factor is whether the RRSP can reliably earn more than the mortgage pay-down’s risk-free return.
The RRSP contribution tax break would make a difference if Jasmine’s tax rate at withdrawal in retirement will be less than now. But she doesn’t know that. Tax would not be an issue if Jasmine was debating between mortgage pay-down and a tax-free savings account (TFSA).
Would your choice be the same as Jasmine’s?
Maybe not. Look at your own situation with care before making any important financial decision. Be sure to get some help from a financial adviser.
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