Housing is one of the hottest topics of conversation lately. Housing is not only a necessity of life but also the most single largest investment for majority of Canadians. Experts from various industries; urban planners, real estate developers, government, economists, mortgage brokers, financial planners and others have recently reported on issues affecting homeowners. Subjects such as affordable housing, residential real estate prices, historically low interest rates, increased density in urban areas, paying down a mortgage and high cost of living in the greater lower mainland have been on top of most peoples’ mind.
One common question we hear as financial advisors, in regard to housing, is “Which is better, pay off the mortgage or buy an RRSP?” To answer this question I will refer to an article written for Money Magazine by a colleague of our firm, Ian Whiting.
Lee and Daphne, age 30, are aware of the huge cost of interest on their mortgage, but are quite ambitious and would also like to retire in their late 50’s or early 60’s. Can they do both at the same time or do they have to choose?
Through diligent saving and a sizeable down payment, their condo mortgage is only $150,000. They are able to afford higher than normal payments so decided on a 20 year term mortgage at a fixed rate of 5%. Over 20 years they will pay about $87,000 in interest, assuming rates don’t change of course. If they decide to make a principal payment of $6000 on each mortgage anniversary, they would pay it off in 11 years and reduce their interest costs to about $46,000. In theory, they would start contributing $6000 to their RRSP after the mortgage is paid off. But is this the best option?
If they choose to wait until age 41 to start making RRSP contributions, assuming a consistent rate of return of 7% to age 60, they would accumulate about $230,000. At current rates, this could pay them a lifetime income of about $1300 per month. Even including OAS and CPP at current maximum rates and applying the effects of inflation for 30 years, up to retirement and beyond, this is not going to provide much of a lifestyle.
Let’s examine this more closely. To pay down their mortgage by $6000 annually, this young couple has to earn just over $9100 before taxes (BC tax rates 2013) . If they made annual deposits of $9100 after their mortgage is paid, using the same 7% rate of return, they could have nearly $350,000 at age 60- which could mean a monthly income of $2000. Better, but not by very much.
So, by doing some reverse math, if they agree to pay off the mortgage in 15 years and starting with $9100 of pre-tax earnings, they could deposit $6800 into their RRSP every year. The estimated tax savings would be about $2300. The $2300 is then used as prepayment for the mortgage. The mortgage would now be paid in full after 15 years with interest costs of $64,000. By putting $6800 per year in to their RRSP and increasing the contribution to $9100 when the mortgage is done, they would accumulate $710,000 at age 60! At current rates this would apply a lifetime monthly income of $4100.
To summarize, their choices come down to 3:
- Eliminate the mortgage in 11 years by making $6000 annual principal payments. Then contribute the $6000 to RRSP’s until age 60. Total interest cost $46,000. A potential RSP fund of $230,000 provides a monthly income of about $1300.
- Pay off the mortgage in 11 years and then start $9100 RRSP deposits each year until age 60. Total mortgage interest costs $46,000. The RRSP total $350,000, potential monthly income of $2000.
- Decide to clear the mortgage in 15 years and contribute $6800 to RRSP each year and apply the tax savings of $2300 toward the principal payment each year. When the mortgage is gone, increase RRSP payments to $9100 per year. Total mortgage interest cost will be about $64,000. However, the RRSP can grow to $710,000 and generate $4100 income per month.
Understanding the time value of money and interest costs are important financial concepts to consider when making these kinds of decisions.
Lee and Daphne decided that the 3rd choice was the better option to accomplish their future goals. It gives them the best of both worlds; pay down the mortgage and allow for saving on taxes with the potential of retirement income from their RRSP. Even though they will pay an additional $18,000 in interest, there is a significant difference in both, the retirement savings and potential for lifetime income. The RRSP more than TRIPLES- increasing by $480,000 from time in the market and compounding rates of return.
Doesn’t it make sense to do the same series of calculations on your mortgage? Happy number crunching!
This article was written with the permission of our advisory team, Ian Whiting, Customplan Financial Advisors Inc. published in Money Magazine, 2014. Sindy Billan, SB Wealth Solutions, is an associate at Customplan Financial. The information in this article are presented for general knowledge and the content should not be relied upon as containing specific financial, insurance , tax or legal advice. Practitioners must seek their own independent professional advice to discuss their personal circumstances before implementing this type of arrangement. SBILLAN Wealth Solutions Inc. doing business as SB Wealth Solutions.