Choose the goal with the better ROI
Weigh the pros and cons of paying off mortgage versus making RRSP contributions
Plagued by crippling household debt, millions of Canadians are torn between saving for retirement and paying off the mortgage, the largest of all debts. For the vast majority of Canadians, the option of doing both is just out of the question.
According to the latest Statistics Canada figures, the debt-to-income ratio among Canadian households has jumped to 166.9 per cent of disposable income, a record high. No doubt the bulk of this debt is resulting from unchecked borrowing led by home purchases.
For those living paycheque to paycheque, choosing between building retirement savings in an RRSP and wiping out the mortgage debt seems like a battle they can never win. So what are they to do? There are two ways of looking at it, says Marie DeLauretis, a Calgarybased certified financial planner.
“One way to think is, ‘I can earn more on my investments than my current low mortgage interest rate,’ ” she says. “The other is, because mortgage rates are so low, you now have greater opportunity to pay your mortgage balance quicker as fewer funds will be used to pay interest costs.”
The higher your interest rate, the more will be going to interest expenses and not home equity, goes the argument.
Many people, however, only consider the short-term implications. Cynthia Kett, a principal with advice-only firm Stewart & Kett Financial Advisors Inc. in Toronto, says people should be thinking about their financial planning as a whole.
“Cash management, tax planning, investment planning and retirement are the key ones in this case,” she says. From a cash management perspective, the question is how disciplined are you?
Some people use a home purchase, financed by a mortgage, as a form of forced savings, Kett says.
“If they pay down their mortgage sooner, will they use that extra cash flow to diligently save for retirement later?” she says. “This is key, because if all they have in retirement is a fully paid-for home and OAS/CPP, they’ll have to sell the house to fund their retirement.”
Kett says for people who lack that discipline, it may be better to contribute to their RRSP. However, she adds, for more disciplined folks, paying down the mortgage may make more sense. “Once mortgage debt is paid off, there will be significant free cash flow available for retirement and other priorities,” she says.
In the current low interest rate en- vironment, paying off a mortgage can be a more prudent choice.
“If we consider paying down the mortgage as a proxy for a safe fixedincome investment which might only yield 2 per cent, the mortgage rates of return look pretty good,” Kett says. “Even in comparison to equity investments — the pre-tax mortgage rate of return is excellent because it’s guaranteed. Equity returns are unpredictable and may be negative.”
Paying down the mortgage, in this instance, wins hands down.
Emotions can also exert strong influence affecting people’s investment decisions. The individual risk tolerance and capacity for risk are important considerations, DeLauretis says. “People prefer to avoid losses to making gains,” she says.
For that reason, when deciding to make a payment toward your mortgage versus an RRSP contribution, an individual must consider return on investment. In the case of mortgage, the return must be calculated in terms of how much money is saved on interest over the life of the mortgage. DeLauretis uses simple math to illustrate her point. For example, she says, with lump sum payment of $25,000 made at the beginning of the mortgage term could result in guaranteed interest savings of $26,394, assuming 3-per-cent mortgage interest rate on a mortgage amount of $500,000, to be paid over 25 years.
In addition, there’s the consideration of “the potential for equity appreciation that is also tax free, when compared to making the RRSP contribution with non-guaranteed rates of returns,” DeLauretis says. Remember, capital gains on a home are tax-free, because of the principal residence exemption.
That’s not to say the RRSP doesn’t have its own benefits, particularly for higher income earners.
“If the individual is in a high tax bracket now, they will be in a lower tax bracket when they retire or when they withdraw the funds — other than for the Lifelong Learning Plan,” Kett says.
“(If ) they plan to leave the contribution in the RRSP for some time (allowing them to grow in value), then contributing to their RRSP may be the best choice.”
But for those who can’t afford to do both, the psychological advantage of being debt-free sooner trumps contributing to a retirement savings plan.
“If paying down the mortgage is a source of happiness, that is a good reason to make it a priority,” Kett says, noting it’s “the least risky option” and one that offers “great rates of return, with no risk.”
After all, who wouldn’t love the feeling of being debt-free sooner, DeLauretis says.
“We must take into account peace of mind achieving a goal or steadily working toward that goal,” she says. “Especially, if it helps to avoid loss, ballooning debt, or the effects of uncontrollable economic factors such as job loss, increasing mortgage rates and life-changing events including accidents, illness and death.”
You made one of life’s biggest purchases — a home. But here comes the next round of financial decisions.