This is one of those debates that will probably rage on without ever clearly being decided anytime soon. So instead of telling you that either paying down your mortgage more quickly OR saving to your RRSP is unequivocally better than the other, I will instead provide you with some insight that will allow you to make a more informed decision for your own situation.
There have been some very adamant proponents for each strategy and I would caution you that when considering their arguments, look at what assumptions they are making with respect to the individuals’ financial situations, investment experiences and attitudes. For example, not everyone has the same asset allocation, rate of return, mortgage interest rate, investment knowledge, etc. So while a compelling argument can be made based on a certain individual profile, the conclusions may not be transferable to other profiles – i.e. YOU! :)
With that in mind, let’s take a look at the basic argument:
By putting money away into your RRSP you are increasing the amount of future retirement income and also increasing your net worth by doing so. By putting extra dollars against the mortgage instead, you are paying off debt – which also serves to increase your net worth since you will have a smaller number on the "liabilities" side of your personal balance sheet. So the argument is: Which strategy increases your financial picture in a better manner OVERALL?
I will begin by making some assumptions for the purposes of measuring and comparing strategies. After a first run through, we will then look at how differences to those assumptions can affect the analyses.
So let’s make the following initial assumptions:
We are dealing with a 30 year old single male who earns $60,000 per year. His salary increases by 4% every year until he is 65, at which point he will retire. He will live to be 90. Inflation is 3%. His investments will earn an average of 8%. He has a mortgage of $300,000 as of December 31st, 2006, and he will average a 6.5% rate of interest on that mortgage which has an amortization of 25 years. His mortgage payment would be $2009.47/month and when that money is freed up after having paid the mortgage off, it will not increase with inflation or with his salary.
I will assume that he doesn’t upgrade his house and that his current house appreciates by 6% per year. I will also assume that after his living expenses and set mortgage payments, he has 5% of his gross salary as a surplus every year (which will be used for savings or debt repayment and that surplus WILL grow by 4% per year in line with his salary). Once the mortgage is paid off in any scenario, the same cash outflow will be re-directed to his retirement savings. Once he reaches 65, I will calculate (using existing tax laws including OAS and CPP income) how much annual income he will have (after tax) to spend and that number will not include pulling out equity from his home at any point.
Scenario A: Saving to your RRSP Now, Not using the Tax Refund Productively
This is pretty straight forward – by putting any surplus funds you have into savings in the form of RRSP’s you will earn a tax refund now and your contributions will grow over time as well. In this particular scenario we will examine what happens to our test investor if he were to take his 5% surplus and put that into his RRSP. Once the mortgage is paid off (which occurs in 2031), he will start taking that mortgage payment amount (which was $2009.47/month) and put it into his RRSP savings account in addition to his regular contributions starting in January 2032.
In this case, he ends up with the ability to spend almost exactly $40,000/year in after tax income (in today’s dollars) from age 65 to 90. I actually pulled the graph from my financial planning software to show what this looks like below. There are a couple of points of interest that I have included, and the graph needs some explanation:
First let’s start by looking at the greenish-blue area on the graph – this represents his total net worth. Next, you’ll see a yellow line which according to the legend represents his "lifestyle assets" which is just another way of saying "his house" in this case. The area under the yellow line represents the portion of his total net worth that is made up of his house’s value. Everything above the yellow line represents his RRSP (in this very simple example).
Further I have highlighted two areas: Point A and Point B. Point A is an inflection point in the rate of growth of his total net worth. You’ll notice there is no corresponding inflection point IN THE SAME YEAR for the house value. This is the year he retires and the inflection can be explained by the fact that he is no longer saving to his RRSP and is now withdrawing from it. His total net worth from this point on is still growing because the increase in value of the house is more than the absolute decrease in value of his retirement savings from this point on.
If you direct your attention to the very right hand side of the graph, where the yellow line and the green area meet – at this point, our test investor has no more retirement savings left, and his entire net worth is made up solely of his house. I have used this "goal" (of completely depleting retirement savings and not encroaching on home equity) as a yardstick for comparing scenarios and I will address the disadvantages of this method later.
Point B on the graph is an almost imperceptible inflection point in the yellow line (the value of his house). Rather, it would be better described as his equity in the house. You would be correct if you surmised that the inflection point here represents the point at which he has finished paying off the mortgage as the rate of change in the slope up to that point is greater than after: this is because up until the mortgage is paid off, the home equity growth is based on principal repayment and growth in real estate value. After the mortgage is paid off, the line increases only by the growth in real estate value.
Based on this scenario – our test investor would have $40,000/year in today’s dollars after-tax to spend in retirement.
This is going to be a lengthy post, so I will split it up into three parts. Next, I will look at the scenario of using the surplus to pay down the mortgage before starting RRSP contributions. In the third part, I will start playing with each variable (investment return, life expectancy, mortgage interest rates, etc) to see how this affects each strategy… stay tuned! :)
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