Paying down this mortgage can wait

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Ray and Barbara differ over what their main financial goal should be.

Barbara, who is 31, works on commission and craves the security of a mortgage-free home. Ray, 32, is a salaried professional who favours RRSPs.

"The idea of being able to retire early appeals to me," Ray says in an e-mail.

So far, the couple have been focusing on paying down their mortgage, which stands them in good stead financially if they decide to have children and live on one income for a while.

"We recognize that this is a risk-averse approach, but given that we are now thinking of starting a family, we feel it would be worthwhile to get a second opinion," Ray adds.

We asked Sue Rechil, planner with E.E.S. Financial in Markham, Ont., to look at their situation.

What Our Expert Says The question of whether to pay down a mortgage or contribute to an RRSP is an old debate, Ms. Rechil says, and, ideally, the decision should depend on two things: first, your risk tolerance; and second, the current interest rate and existing investment climate.

For those who have company RRSPs or defined-contribution pension plans that include a match by the company on your contributions, the appeal of paying down your mortgage aggressively is considerably reduced, she notes.

"You are getting an instant rate of return on your RRSP or pension contributions, often as high as 100 per cent if the company match is dollar for dollar."

In the case of Ray and Barbara, there is no such company match, so the decision of what to do with their accumulated cash savings is a little more difficult.

They have a great variable rate mortgage, currently at only 1.35 per cent. Given that the higher income earner, Ray, is in a 43.41-per-cent marginal tax bracket, he must earn $2.39 of income to make the $1.35 (after paying $1.04 of tax) needed to pay the interest on $100 worth of mortgage principal.

So, effectively, paying down the mortgage will generate the equivalent of a 2.39 per cent rate of return on the lump sum payment, Ms. Rechil notes.

Barbara and Ray are allowed to make extra mortgage payments, over and above their regular monthly payments, of as much as $84,000 per year.

The couple's strategy of aggressively paying down their mortgage over the last few years has enabled them to be in a position to start a family in the next few years if they so choose. After all, they have a $450,000 home with only a $179,000 mortgage.

Whether either Ray or Barbara is home for a one-year maternity or paternity leave or one of them becomes a stay-at-home parent for an extended period, they have a lot of equity built up in their home that could be used to supplement their incomes, Ms. Rechil says.

A bank will lend them up to 80 per cent of the home's value ($360,000) less their mortgage ($179,000) as a secured line of credit at prime plus one percentage point (3.25 per cent currently).

They could obtain a secured line of credit for $181,000 on which they could draw if required, which is a fairly large emergency fund, she adds. They are well positioned to accommodate either a short parental leave or an extended period with only one income.

Barbara and Ray have $60,000 of cash savings, a portion of which is earmarked for a car purchase. These savings are currently earning about 1 per cent - perhaps less, Ms. Rechil says.

"We calculated that paying down their mortgage was the investment equivalent of buying a 2.39 per cent guaranteed investment certificate and that at Ray's level of income, they can get a 43.41-per-cent tax refund on RRSP contributions.

"Both options seem more lucrative than leaving the money in the savings account."

If they use it for an RRSP contribution and earn the same 1-per-cent rate as in their savings account, at least they are getting a tax deduction on the RRSP contribution and the income is accumulating on a tax-deferred basis, Ms. Rechil says.

Ray has $100,000 in company stock. He could transfer some of the shares to his RRSP as an "in-kind" contribution. The value at the time of transfer is considered the amount of the contribution and an RRSP contribution receipt is issued.

However, in his case, the shares have a $50,000 cost for tax purposes. Transferring shares to an RRSP is considered a deemed disposition. Because the shares have doubled in value from the original cost, 50 per cent of this gain will be taxable on his tax return as a capital gain (only 50 per cent of capital gains are taxable).

"In that there is a significant gain in his company shares, this is not the most tax effective strategy for Ray."

Given that Barbara and Ray have a medium-risk profile, it is likely they could make an RRSP contribution and earn a rate of return over the next year higher than the 2.39 per cent return Ms. Rechil calculates they would effectively get on a lump-sum mortgage payment.

Without considering investing in the stock market, the rates paid by corporate bonds or bond mutual funds could potentially beat a 2.39 per cent rate of return, with only moderate risk, Ms. Rechil says.

Furthermore, RRSP contributions made by Ray result in a 43.41-per-cent tax deduction (31.15 per cent for Barbara) and a resulting tax refund next April.

So, Ms. Rechil suggests making an RRSP contribution using Ray's RRSP room (as he has the higher income and marginal tax rate) and investing it conservatively with the expectation of beating 2.39 per cent.

The amount of the contribution should be modest, as they want to use some of the cash in their savings account to purchase a new car for Barbara.

"Being that their current mortgage rate is so low, making an RRSP contribution, which could potentially earn a higher rate of return, is a good alternative at this time."

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Special to The Globe and Mail