What’s more beneficial: investing in RRSP or paying off mortgage?
There are funds to contribute to RRSP program, but wouldn’t it be better to put that money into the house and as result reduce the amortization period?
Here is how this can be addressed: of course for all new home owners (and there are many), the first instinct is to pay off mortgage as soon as possible, consequently, pay less hard earned money in interest to the bank! Let’s analyze the situation. A family has purchased real estate and mortgage amount was $450,000 at 3.5% interest (for example). Question: what to do – contribute $10,000 into an RRSP or pay off some mortgage, as friends will suggest. At first glance, paying off is more beneficial. As the total payment amount on mortgage in 25 years will be almost double the original loan amount (widely spread rumour).
Let’s look at the actual numbers. In 25 years of its existence, total mortgage payment amount will be $674,014 (principal & interest). A portion of payments that paid to the bank in the form of interest will be $224,014. Not a very nice picture. If in one years, you prepay $10,000, the total amortization period of the mortgage will become 10 months shorter and the amount of total interest paid out will now become $211,320. In other words, actual benefits will be $12,694 ($224,014 – $211,320). Even more than $10,000 prepaid. Great! We used a mortgage calculator on the web site of one of the largest brokerages in Canada www.DominionLending.ca – http://www.dominionlending.ca/mortgage-calculators.
Now let’s look at what will happen to $10,000 invested into an RRSP. $10,000 placed into moderately risky funds, provide an average annual return of 4.5% over 23.2 years (We used 23.2 years because the funds were invested a year after the mortgage began, and the mortgage payout is expected to be completed in 23.2 years). Some times better, some times worse, but 4.5% is a very realistic number. Even simple government bonds, over a long period of time offer such returns. $10,000 with a return of 4.5% will become $27,765 or $5,071 more, than with the early mortgage prepayment on property ($10,000 prepayments and $12,694 savings on the interest). When You pay off loans early, you are essentially stopping bank from earning interest on the $10,000. If, however, you invest that money, you receive interest on the $10,000, furthermore,earnings continue to work for you and bring additional profit.
In other words, by paying out mortgage, you are not letting the bank make earnings, but You don’t earn as well. At the same time, your compounded interest in an RRSP, with years, brings more earnings than the benefits of paying off your mortgage. Consider that we haven’t considered the tax return aspect of contributing into an RRSP. With an income of 43 to 87 thousand a year, the return would be 21%, which is $3,100. This amount, with the same investment returns would turn into $8,236 in 22.2 years (1 year less than the 23. Years from earlier due to the fact that tax returns will be received next year). Adding together $27,765 and $8,236 will be $36,001. Compare that to $22,694, the benefit of early mortgage payout. This is considering that $22,694 looked like a good option at first. Even if we get rid of taxes, for example 21%, as upon retirement, tax brackets tend to be lower, we would still have $28,440 on hand, which s higher than $22,694.
This example is not a directive to act, it is still necessary to do a full analysis of your financial situation. For example, if a person’s income is below $43 thousand a year, investing into pension plan is absolutely not beneficial, as the person would not be able to earn full pension and it is likely that, at retirement, receiving pension from RRSP may result in reduction of social assistance to low income families. So with a smaller income it would be better to make early payments on mortgage. At the same time, if the person’s income is over $100 thousand, the return from RRSP contributions will be 40%, which makes the RRSP contributions more attractive than paying out mortgage.
What do you think about this offer – contribute money into an RRSP, receive tax return, and use this return to make an early payment on your mortgage? Killed two birds with one stone – pension program is working, and bank loan is reduced. Maybe this is the golden middle. May be, but analysis of specific family and financial situation is still necessary before making any decision.