RRSP vs. Mortgage

For many years, the average person assumed that purchasing a house was a good investment for retirement. Therefore, buying a home became the largest investment -- and in many cases the only investment -- the average person made in their lifetime. In order to finance their purchase, many new homeowners had to borrow money by assuming a mortgage. Family, friends, associates, and financial professionals often recommended reducing the mortgage as soon as possible to avoid paying substantial interest payments. This was, and always has been, good financial advice.

Today, for many people, this scenario still holds true. And in many cases, purchasing a house may still be the largest investment the average person will make. Unfortunately, as we have recently witnessed, real estate markets are susceptible to substantial volatility and housing prices can increase or decrease in response to many different economic and political scenarios across Canada. What was once a "sure fire guarantee"
can become an uncertainty in the future. As homeowners, we certainly hope that the market value of our home will rise substantially over time or at least maintain its purchased value. While it makes financial sense to eliminate debt as soon as possible, it is also just as important to diversify your investments by building an RRSP. The purpose of this section is to demonstrate that you can do both -- reduce your mortgage while at the same time make contributions to your RRSP.

Let's examine the alternatives

Assume that you are a homeowner with a $100,000 mortgage, a mortgage interest rate at 8 per cent per annum, and make monthly mortgage payments of $836. You have 20 years until retirement. Currently, you have $5,000 available in savings and cannot decide whether to invest in an RRSP, pay down your mortgage, or do both.

The choice between paying down the mortgage and investing in your RRSP depends upon critical assumptions: the interest rate on the mortgage, the rate of return on the investment in the RRSP, the rate of return on the investment of the tax refund received for any RRSP contribution, and the rate of return on the investment of increased cash flow generated by early pay-off of the mortgage.

However, there is a way to do both. You can contribute to the RRSP and pay down the mortgage as well - You invest your savings in an RRSP, receive a $2,000 tax refund assuming you are in a 40 per cent tax bracket, and use your tax refund to pay down your mortgage.

Over a twenty year period, if your $5,000 investment in an RRSP earns an 8 per cent annual rate of return, the investment would be worth $23,305.

With the lump sum payment of $2,000 on the principal amount of your mortgage you have reduced the principal from $100,000 to $98,000, reduced your amortization period by one year, and saved approximately $9,900 in interest. Your combined savings of $23,305 in your RRSP and interest savings of $9,900 total approximately $33,205.

You could continue to benefit even further from this long-range savings plan by investing your interest savings, which will generate additional returns.

By choosing to invest in an RRSP and using the tax refund to pay down your mortgage, you are in essence diversifying your investments, reducing your investment risk, and increasing your earning potential. And, bear in mind, the above scenario is based on a one-time contribution - think of the benefits if you were to implement this practice over the long term - you would be building an RRSP and substantially reducing the principal, amortization, and interest payments of your mortgage.

In fact, in today's economic environment, it makes even more sense to take advantage of historical low mortgage rates by continuing to invest in your RSP where possible. This could be even more advantageous in that you would be investing in equities at their most depressed levels experienced in the last four years, helping you diversify further from real estate, which is sitting at its highest price levels that we have seen in some time.