What to do … contribute to your RRSP or pay down your mortgage: what the last 15 years tell us

January 3, 2013 by Editor, InvestingForMe

The average Canadian has always had limited savings and every year they wrestle with the same nagging question: Should we contribute to our RRSP or pay down the mortgage?

And every year when you ask for professional advice you hear the same answer: 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.)

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 illustrate just how badly we got it wrong, let’s look at the numbers for an average Canadian. Using this data (including Statistics Canada’s average income figures, average RRSP contributions and mortgage requirements), let’s do some simple math comparing the average Canadian’s finances when contributing to an RRSP vs. paying down a mortgage. You just might be surprised.

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.

Background numbers

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.
• 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

• You took out your mortgage in January 1998.
• You just purchased a home and took out 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 5-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%)

• You’re an average Canadian and have contributed \$4,670.00 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!)
• In 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 slightly better scenario, let’s assume you’re not an 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: If we look at the stats over the same 15-year period, the S&P/TSX Composite Index and the S&P/TSX 60 Index only averaged 6.02% and 6.58%, respectively, with most individuals actually earning less and paying more in fees. (According to BlackRock, 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, then the numbers are even stronger for ignoring the pouring of your savings into an RRSP until after you pay off your mortgage.

So, now for the math …

The following chart summarizes the calculations we've derived from IFM’s new calculator to be used in our what’s-the-best-bet comparison exercise.

Remember: The numbers we’re using are for an average Canadian financial profile only, but the numbers will add up to the same answer for most Canadians!

 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% Mortgage amortization period (years): 25 Mortgage compounding period: Semi-annual Mortgage payment frequency: Monthly Mortgage savings (after-tax): Extra principal payments: \$70,050.00 Interest savings: \$91,156.30 Accumulated value (after-tax): \$161,206.30 At this rate your mortgage will be paid off in: 15 Years Choice #2: Using my savings for my RRSP contribution Do you spend your RRSP tax refund? Spend it! Average annual rate of return: 10.51% Estimated annual investment costs: 2.06% Average annual rate of return - net of costs: 8.45% Investment compounding period: Annual Estimated pre-retirement income tax rate: 35% Estimated retirement income tax rate: 17% Accumulated RRSP value (before-tax): \$131,330.24 Accumulated after-tax RRSP value: \$109,004.10 Estimated RRSP investment costs for the 15-year period: \$17,644.73 Conclusion: Paying off your mortgage first would generate thistotal interest and investment costs savings: \$108,801.03

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.

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 (and what the pros aren't telling you!)

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 will give you a bigger Tax Refund, today, 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 means 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 a retirement nest egg of \$303,381.15 after just 10 years and over a 15-year period would grow to \$576,473.94.

So, why aren't our investment advisors showing us the math?

It’s real simple – money. When you ignore your RRSP and pay down your mortgage, your bank makes \$91,156.30 less in interest income from you and the investment advisors are \$17,644.73 poorer. They also wouldn't have your \$131,330.24 RRSP to work with and charge fees for. That means very simply that a lot of bankers and investment advisors would be out of work.

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 us 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 before rates rise is probably a good strategy, right?

So, in light of these answers, I would still highly recommend the average Canadians pay off their 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 have socked money into a savings account while they still owed the bank. To them, that would have been down right stupid.