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What does the future say… pay off the mortgage or build up the RRSP?

December 30, 2013 by Editor, InvestingForMe

The hardest part about making financial decisions is that nobody knows what the future holds. Yet all of our really big financial decisions, like paying off the mortgage and contributing to RRSPs, are dependent upon what happens in the future.



For instance, how much house we can afford will depend on

  • future interest rates (over the 25-year life of our mortgage),
  • our future career success and failures, and
  • future real estate values.

And how much we need to save for our retirement in the form of RRSPs will depend on

  • the future rates of inflation
  • the future level of interest rates
  • the future value of stock markets, and, of course,
  • how long are we going to live in retirement – nobody wants to run out of money and head back to work in their 80s!

So, the only way for us to make these big financial decisions is to make assumptions about the future where sometimes these assumptions are rooted in history and sometimes they’re simply based upon the forecasts (i.e. crystal ball gazing) of experts.

Making assumptions about the future

When making financial decisions, it’s impossible to make assumptions about everything in your future (i.e. your health, longevity, family outcomes, career paths, etc.), so we typically reduce the list to one or two simple but important assumptions – namely interest rates, which have a major impact on the cost of our mortgage, and investment rate of returns, which impact our retirement savings.

And to help us make these assumptions, we can use the following three approaches:

  • We can use history as a guide and assume that it will simply repeat in the future.
  • We can use the forecasts created by financial professionals.
  • We can use both.

Using history to predict interest rates and investment rate of returns

Some people like to look to the past as their guide to making future financial decisions. However, while simply taking the past and projecting it forward sounds simple and easy, it has not proven to be a successful method for predicting our future! This approach makes a very simplistic (and incorrect) assumption that tomorrow’s world (society, technology, science, demographics, attitudes, etc.) will be identical to today’s and yesterday’s world. In other words, nothing will change! As we all know from experience, the only thing that doesn’t change is change itself.

So when it comes to reliably predicting future interest rates and investment trends, relying on history to repeat itself has proven to be an abject failure. This fact is the reason why most investment products come with the ominous warning – past performance is not a guarantee of future investment performance. And why you’ll often hear people say that economists have successfully predicted 9 of the last 5 recessions. They just can’t know the future!

So, relying on history alone is not the answer.

Crystal ball gazing: not as simple as it looks either

Wouldn’t it great if we had a crystal ball to answer all of our financial questions about the future? Just think of a question, stare into the crystal ball and … poof! You get the answer. Sorry to burst your bubble, but no such tool exists.

But fortunately for us small guys we’re not facing this dilemma alone. We don’t need a crystal ball or a PhD in finance, and we don’t need to create our own forecasts. Why burden ourselves when finance and investment professionals are already making assumptions and generating forecasts? We can piggyback on their expertise! They’re faced with the same future uncertainties we are and they’re making the same investment decisions we face! The only difference between us and them is the dollar amounts invested – our tens or hundreds of thousands of dollars vs. the millions and billions of dollars they manage! So if we’re going to use forecasts for interest rates and investment returns in our financial decisions, why not simply borrow from the professionals?

Well, the truth is that even though the pros are smart, educated and experienced, they still don’t possess a crystal ball either. Their forecasts are just estimates of what they think will happen – i.e. still only guesstimates (although pretty educated guesstimates at that and still probably better than our own!), and their forecasts still require constant, careful monitoring and adjustment if they’re to remain valid. In other words, while relying upon professional forecasts can be helpful when making financial decisions, it’s not 100% foolproof either to helping you make those all-important decisions about your savings.

Door #3: keep one eye on history and one eye on the professional crystal ball gazers

While we can’t rely 100% on the past or future predictors, perhaps the best option to making your big financial decisions involves learning something from them both about the future of interest rates and investment returns.

Here’s what they both can tell us about mortgage interest rates:

  • The past: According to the Bank of Canada, history tells us homeowners have paid, on average, 7.01% for the past 20 years on their mortgages.
  • The future: The professionals at Canada Mortgage and Housing Corporation (CMHC) are forecasting that mortgage interest rates will increase from the current 5.34% to 6.25% by the end of 2014. Finding a forecast beyond 2014 is virtually impossible.

And here’s what the past and future predictors can tell us about investment returns in an investment portfolio that is invested in both stocks and bonds,

  • The past: According to Russell Investments, history tells us that investors have earned 8.48%, each year for the past 20 years, before adjusting for inflation and investment costs.
  • The future: The professionals at the C.D. Howe Institute are forecasting long-term investment returns of 4.7% per year, with most private company pension plans forecasting returns to be 6.50%, before adjusting for inflation and investment costs.

The take home: somewhere in between

So, what is the average Canadian investor to do with all these numbers when it comes to making the hard decisions about paying off the mortgage vs. investing in RRSPs? Well, when it comes to trying to make those decisions today, you’re probably best to use numbers that fall somewhere in between the historical ones and the experts’ forecasted future ones. For example, I like to average the two numbers. So when making mortgage decisions, plan for long-term mortgage interest rates to average 6.63%, and when it comes to your investments maybe a long-term average rate of return of 7.49% makes sense.

Next week, we’ll wrap up this series with an out-of-the-box strategy for you to think about when you’re faced with that annoying question – What should I do, pay-down my mortgage or contribute to my RRSP?


(This article published by Troy Media)


Read the next article in the series - RRSP contribution or extra mortgage payment: an out-of-the-box strategy


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



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