One question I was often asked when I worked in banking was, “Should I pay down my mortgage or maximize my RRSP contributions?”
Being a good employee concerned with the (you know who’s) bottom line, the simple answer was usually, “Maximize your RRSP contribution, then use your (considerable) tax refund to make a lump sum mortgage payment.”
You’ve heard this many times before.
What if you wanted a more detailed answer from your banker?
Maybe you’ve had the same experience as this couple:
Banker (reaching for his calculator): Okay, say you put $5,000 down on your mortgage and keep the payment the same, you will reduce your balance and pay it off in about 11 years. Then if you make the same payment to your RRSP, at a rate of 5%, in 2 years you will have $23,966, but this is before tax. Let’s say you’re in the 40% tax bracket, you’ll have $14,380. But this ignores the tax refund, which you could also invest which would amount to $39,920 or $23,592 after tax. Now on the other hand, if you contribute the $5,000 to your RRSP today you will accumulate.., blah, blah, blah….
Eyes glazed after hearing too much detail, the couple leaves the bank, still not knowing which strategy to use.
Related: Can You Trust Advice From Your Bank?
If you were to ask me that question today, the answer would be – it depends.
You could consider how the rate of return on your investments, interest rate on your debt, tax rates and time horizon can impact your decision.
But, instead of doing mathematical gymnastics and trying to predict the future, consider these suggestions:
When you should pay down your mortgage – or other debt
It makes no financial sense to pay 18 – 29.9% interest on credit card balances. Pay these down first, then any loans and lines of credit you may have, then your mortgage.
If you have a large mortgage payment that could become onerous if the interest rate increases on renewal, pay extra on your mortgage. On a $400,000 mortgage, after 5 years, the monthly payment will increase almost $200 if the interest rate rises by 1%, and about $350 if the rate goes up 2%. Paying extra could smooth out your payments down the road.
Related: How To Pay Off Your Mortgage Faster
If you are over 50 years old, pay down your mortgage. If you are still in debt when you retire, you will be paying out valuable resources that could be used for a better quality of life, instead. Also, if you want to downsize in the future, or participate in a reverse mortgage plan, you’ll have more equity in your home to work with.
Contribute to your RRSP
If your mortgage balance is moderate and/or you are paying an exceedingly low interest rate, put the money into your RRSP.
People who are not enrolled in any type of employer-sponsored pension plan or group RRSP will probably find themselves in a significantly lower tax bracket on retirement. Funding the RRSP, as much and as early as possible, can make a big difference in income.
If you earn a high salary and an RRSP contribution will bring your taxable income down to a lower tax bracket, you should take advantage and receive the larger tax refund.
Psychologically, paying down debt just feels right. On the other hand, contributions to an RRSP benefit from compounding and tax deferment, as well as giving you access to cash in the event you lose your employment income (which keeps you from losing your house).
In any event, whether you have a lump sum amount, or an extra couple of hundred dollars a month to work with, you are still ultimately saving for the future with either approach.
And you can still make a lump sum mortgage payment with your tax refund.