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RRSP contribution or extra mortgage payment: an out-of-the-box strategy

January 6, 2014 by Editor, InvestingForMe

When it comes to the debate about contributing to an RRSP or paying down the mortgage, we’re all familiar with the two standard strategies promoted by the investment world – the one extreme and the compromise:

 

 

  • It’s all about your RRSP: Strategy #1 - It’s important to save for your future retirement, so use your extra savings to build a retirement nest egg

Or, if you really want to focus on paying down your mortgage, then they suggest…

  • The Compromise: Strategy #2 - It’s important to save for your future retirement, so use your extra savings to build a retirement nest egg and then use your income tax refund to pay-down your mortgage.

But what about the 3rd strategy that one no one ever talks about? Well, there is one, and while this out-of-the-box strategy may seem crazy because it’s so simple, I assure you it’s not.

The 3rd strategy: all about your mortgage

The 3rd strategy is the simplest option of all where you ignore contributing to your RRSP and saving for your retirement until after your mortgage is paid off. With this strategy, eliminating your mortgage is your number one priority.

With this strategy you’ll still continue to save for emergencies and your children’s education with the aid of Registered Education Savings Plans (RESPs) and Tax-Free Savings Accounts (TFSAs), but everything else (i.e. including savings normally earmarked for your RRSP) will be diverted to paying off your mortgage.

And surprisingly this one simple diversion can make a huge difference in savings to your financial picture.

Hard to imagine? Well, let’s compare numbers in contributing to your RRSP (using the typical, recommended strategy #1) vs. thinking outside the box and paying off your mortgage first (using strategy #3.)

Paying off your mortgage according to the standard strategy #1

So let’s assume you’re an average Canadian (as we did in our previous article) and that you’re 30 years old and have just bought your first house (paying $300,000) with the help of an average sized mortgage ($256,000), which you plan to have paid off by the time you turn 55 (i.e. in 25 years).

Here’s a brief summary of what those numbers would look like.

 

Home's purchase price$300,000.00
  
Mortgage details: 
Principal outstanding$256,000.00
Interest rate: 25-year average6.63%
Amortization period25 Years
Compounding periodSemi-annual
Payment frequencyMonthly
Total payments: monthly$1,734.97
Total payments: each year $20,819.64
  
Total mortgage interest paid over 25 years$264,492.39

Total cost to buy your home (after-tax)

(Home's purchase price + mortgage interest paid)

$564,492.39

  

So, as you can see if you stick to the standard plan, make your monthly payments, and have the mortgage paid off in the allotted 25 years, you’ll have paid your lender $264,492.39 in mortgage interest! Looking at the results of this strategy another way, you’ll see also a couple of other alarming numbers:

  • On average, you will have paid your lender $10,579.70 each year, for 25 years, in mortgage interest with after-tax money, and
  • You didn’t pay $300,000 for your home. You actually paid $564,492.39 for your home (after-tax).

D’oh! So, did you know you were signing up for throwing so much of your hard-earned cash away on interest payments? No wonder those loan managers act so friendly when we walk in the door to borrow money! These numbers demonstrate how and why your home is not only your biggest asset, it’s also your most costly one as well where if you stick to the investment world’s standard plan, you’ll pay your lender a lot of extra cash for that loan!

Troubles with strategy #2

While contributing to your RRSP and using your income tax refund to pay down your mortgage debt is a better strategy than strategy #1, unfortunately most Canadians don’t have the discipline to follow it. History tells us the vast majority of Canadians think of their refund as some kind of reward and they end up spending it. In fact recent studies tell us only 24% of Canadians actually contribute to an RRSP and out of that 24% the overwhelming majority – 62% – plan to reward themselves by spending their refunds on stuff. When these numbers are calculated, they show that only 1.5 Canadians out of every 10 try to follow strategy #2. So obviously strategy #2 is not working very well!

Paying off your mortgage: strategy #3

Now let’s assume you adopt strategy #3 – ignoring your RRSP and using your extra savings to pay down your mortgage as soon as possible. What would the numbers look like then?

 

Home purchase price$300,000.00
  
Mortgage details: 
Principal outstanding$256,000.00
Interest rate: 25-year average6.63%
Amortization period25 Years
Compounding periodSemi-annual
Payment frequencyMonthly
Payments: monthly$1,734.97
Payment: extra annual$3,455.00
Total payments: each year $24,274.64
  
Your mortgage is paid off in 18 years7 years early!

Total mortgage interest paid over 18 years

(Saving $82,786.08 in mortgage interest costs)

$181,706.31

Total cost to buy your home (after-tax)

(Home's purchase price + mortgage interest paid)

$481,706.31

  

Wow! Now don’t those numbers sit better? In addition to saving more than $82,000.00 in mortgage interest costs and because you don’t have any RRSP investments, your savings are even greater:

  • You’ll have saved over $17,314.82 in investment management costs – making your total out-of-pocket savings $100,100.90.
  • That’s an average annual savings of $5,561.16.

And then once you have paid off your mortgage, by the time you’re 48, you can then start putting savings away for RRSPs.

Mortgage gone – now it’s time to focus on retirement savings

By now I bet you’re probably saying to yourself something like…. Well that’s great, I’ve paid off my home, but now I’m 48 with nothing saved for my retirement! Right! And you’re right, but now think of all that extra $24,274.64 in free and available cash you’re going to be able to put away each and every year! Let’s look at how those numbers will add up:

  • $446,000.00: That’s the amount of retirement savings you could have by the time you turn 60, if you invest the $24,274.64 each year (even more if you include that larger annual RRSP income tax refund) and earned a 7.49% rate of return
  • $782,000.00: That’s the amount of retirement savings you could have by your 65th birthday!

Now, if all these numbers alone don’t convince you to think outside the box when it comes to paying off your mortgage first vs. contributing to your RRSPs, then read our next article to see what other benefits this 3rd strategy provides to your overall financial health.

 

(This article published by Troy Media)

 

Read the next article in the series - Thinking outside the box: more benefits to focusing on your mortgage

 

Read the 1st article in this series - What to do … contribute to your RRSP or pay down your mortgage?

 

 

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