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What to do … contribute to your RRSP or pay down your mortgage?

December 17, 2013 by Editor, InvestingForMe

The average Canadian has always had limited savings and every year they wrestle with this same nagging question.

 

And every year when they ask for professional advice they 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 is the right answer.

But guess what? Did we ever get it wrong! Using what we know today about mortgage rates and investment returns over the past 16 years, we so-called experts can now give average Canadians a new answer: forget about your RRSP until after you pay off your mortgage.

Before you click away thinking I’m some kind of misinformed nut-bar, let’s look at the numbers using some average Canadian household finances:

  • 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.

And a few basic assumptions about the average Canadian household mortgage:

  • You took out your mortgage in November 1998.
  • You just purchased a home with a mortgage of $190,000 (much less than the current average mortgage of $256,000).
  • You chose to pay back (amortize) your mortgage over a 25-year period.
  • You’ve always been conservative and used 5-year fixed mortgage from your bank, paying an average 6.95% interest rate over 16 years. (1998=7.15%, 2003=6.50%, 2008=7.20%)

And some basic assumptions about your RRSP savings:

  • You’re an average Canadian and have contributed $3,544.00 annually to your RRSP, and just like the average Canadian, you spend your RRSP income tax refund every year - instead of re-investing it!
  • In each year your personal income tax rate was 29% and you anticipate your retirement tax rate to be 12% (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 the same investment management fees as the average Canadian at 2.06% - each and every year.
  • And let's assume you are an investing Super-hero (a little wiser and luckier than the average Joe investor), let’s imagine a scene where for the past 16 years you’ve generated an averaged rate of return, before fees, of 10.92%, annually on your RRSP investments. (In other words, you were a disciplined Buy & Hold investor – reinvesting all your dividends with the disciple of the TSX Total Return Index.)

Note: According to BlackRock the average Joe investor only earned 2.10% over the 20 years between 1991-2011. So if your RRSP investments averaged less than the 10.92% used in this example, the numbers are even stronger for ignoring the pouring of your savings into an RRSP until after you pay off your mortgage.

So, how do these average numbers add up when it comes to the old debate of what to do with that extra $3,544.00 in savings? Do I pay down my mortgage or contribute to my RRSP? Let’s compare the numbers.

Choice #: Make extra mortgage payments
  
Mortgage Details:
Princial outstanding$190,000.00
Interest rate6.95%
Amortization period25 Years
Compounding periodSemi-annual
Payment frequencyMonthly
  
Mortgage savings (after-tax) 
Extra principal payments$56,704.00
Interest expense saved$79,084.49
Accumulated value (after-tax)$135,788.49
  

# of years in which your mortgage

will be paid off

16 years

(That's 6 years early!)

 

Choice #2: Make extra RRSP contributions
  
RRSP Details: 
Do you spend your tax refund?Average Canadian does!
Annual rate of return on investments10.92%
Annual investment costs2.06%
Annual rate of return - net of annual costs8.86%
Investment compounding periodAnnual
  
Pre-retirement income tax rate29%
Retirement income tax rate12%
  
Accumulated RRSP value: (before-tax)$115,579.82
Accumulated RRSP (after-tax)$101,710.24
  

RRSP investment costs

for the same 16-year period

$16,069.91

Note: The numbers expressed in the tables above were calculated using IFM's RRSP vs Mortgage calculator.

So? The numbers above clearly demonstrate how paying off your mortgage first will save you a lot of money! The average Canadian would save $79,084.49 in mortgage expense and $16,069.91 in RRSP investment costs – that’s a whopping $95,154.40 in actual, out-of-pocket expenses saved by simply ignoring your RRSP until your mortgage was paid off!

Or to put it in more tangible terms, that’s

  • $5,947.15 / year, or
  • $495.60 / month for 16 years in savings!

And yet most of us continue to just roll along contributing to our RRSPs first. Why?

That’s a question we’ll tackle next week.

 

(This article published by Troy Media)

 

Read the next article in the series - Mortgages and RRSPs: big business for your bank

 

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