Continuing from Part 1, now we will examine the next scenario…
Scenario B: Pay down the mortgage first – RRSP refund not used productively
In this scenario the set mortgage payment remains $2009.47 BUT, additional funds are directed over and above the set payment. The surplus (of 5% of the sample investor’s gross salary – which is also growing in line with his salary at 4% per year) will serve to accelerate the mortgage – and once it is paid off, all of those funds ($2009.47/month + 5% of his ever growing salary) will be directed to his RRSP.
Here is the new graph:
You are already familiar with the basics of the graph as described in Part 1 of this series – so let’s just focus on what’s different. Point A is of interest because in this scenario surplus funds are used to pay down the mortgage – so the net worth is equal to the equity in the house – hence there is no green area above the yellow line.
The mortgage is, however paid off much earlier than 25 years. In fact it is paid off 7 years earlier (2024). Now the 5% surplus in ADDITION to the $2009.47/month set mortgage payment from before is now directed to the RRSP account. This is shown in Point B – which represents two points of inflection. The first point of inflection is the yellow line which represents the slowing growth in the house equity. This is due to the fact that payments are no longer going to reduce the mortgage and the remaining growth is just the 6% increase we have attributed to real estate appreciation. The second point of inflection (at Point B) is for the total net worth – which is now increasing more quickly since the surplus funds and the old mortgage payment amount is being directed to an asset with a higher growth rate than the real estate appreciation rate (8% vs 6%, respectively).
There is a third inflection point (which is not located at Point B), but occurs as usual at the time of retirement when our sample investor transitions from saving to spending.
In this scenario, our sample investor will be able to spend approximately $38,000/year after tax, in today’s dollars from age 65 to 90. You can see that this is less than Scenario A. But don’t let this fool you into thinking the debate is over – far from it… Let’s look at what happens when we use the RRSP refund productively in the next two scenarios:
Scenario C: Save to RRSP now, use tax refund to pay down mortgage
This is the same as Scenario A, with the added difference of productively using the tax refunds generated by the RRSP contributions.
First we will need to calculate the amount of the tax refund – it will be $935 in Ontario and we will apply this yearly (and index it at 4% to match the growth in his salary). Since his salary is growing faster than inflation, it is possible that our sample investor will move up through a tax bracket and start generating proportionately larger and larger tax refunds, but the difference will not be statistically significant as the differential between his salary and inflation is only 1% per year (and the tax brackets are supposed to increase with inflation). Once the mortgage is paid off, the RRSP refunds will be directed to a non-registered portfolio which will be used to augment retirement income later (also keep in mind the RRSP refunds will take a big jump once the mortgage is paid off as $2009.47/month will now be directed to the RRSP each year after that point). This portfolio will be in a taxable account, so we will use the same 8% long term rate of return but we will model the returns as 2% dividends, 1% interest, 1% realized capital gains and 4% unrealized capital gains per year – this way we can take into account the reduced growth due to taxation.
It might be hard to tell, but area above the home equity (yellow line) is "bulkier" than in Scenario A – this is because more money is being accumulated for retirement savings. When factoring the use of the RRSP refunds to first pay down the mortgage (which takes 2 years and 11 months off the 25 year amortization schedule), and then to fund a non-registered retirement account – this strategy allows for an annual, after-tax income in today’s dollars of $46,300/year from age 65 to 90. So you can see, using the RRSP refunds productively is a big deal.
Now we must factor the productive use of the RRSP refunds for Scenario B to be fair…
Scenario D: Pay down mortgage first, then save to RRSP with productive use of RRSP refund
This is similar to Scenario B – with the addition of productively using the RRSP refund.
So in this scenario, the surplus funds are going to be directed to aggressively paying down the mortgage first, and once that is done, the funds will be directed to an RRSP account. The resulting RRSP refunds will be directed into the same non-registered account as above.
The above graph again shows that for the first little while, no net worth attributable to retirement savings exists as all money is being put towards the mortgage first, and then later to the retirement savings. You may be surprised at first to know that the annual after-tax income in today’s dollars is $48,000/year from age 65 to 90 in this case – you’ll notice the area above the home equity (yellow line) is the "bulkiest" of all 4 scenarios so far.
So to recap:
Scenario A = $40,000/year (RRSP all along, non-productive use of RRSP refunds)
Scenario B = $38,000/year (Mortgage first, non-productive use of RRSP refunds)
Scenario C = $46,300/year (RRSP all along, productive use of RRSP refunds)
Scenario D = $48,000/year (Mortgage first, productive use of RRSP refunds)
So Scenarios A and B might have led you to believe that saving to your RRSP all along might be the better way to go, but the tables are turned once we start using the RRSP refunds to productive use…
The reason is mostly due to the fact that with the mortgage now aggressively paid off early, the mortgage payment amount which is then directed to the RRSP will generate very large tax refunds from a relatively early time (which is then used for non-registered retirement savings).
Okay, I’ve just hit you with three more charts and a few things to think about, so I’ll wrap up Part 2 right here. In part 3, we will start playing around with return rates and interest rates. We w
ill also examine some less quantitative aspects of the old "Mortgage versus RRSP" debate. Stay tuned yet again! :)
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