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One of the more difficult financial decisions individuals must make is whether to contribute money to an RRSP or use that money to pay down their mortgage. Both have significant financial benefits. A payment against the mortgage will reduce the total amount of interest paid and pay the mortgage off sooner. On the other hand, the RRSP contribution will grow to create an income at retirement.
One way of determining which option is better is to calculate the interest savings on the mortgage and compare it to the tax savings and investment earnings of the RRSP.
Example #1: let’s say you have a mortgage of $100,000 at 6% that will be paid for over the next 25 years. You can also contribute to an RRSP and invest in a term deposit paying 4%. You are in the third tax bracket so any tax deductions are worth 36% in tax savings.
| If you pay an extra $1,000 against the mortgage, your interest savings would be ($1,000 X 6% X 25 years). | $1,500 |
| If you contribute $1,000 to your RRSP, your tax savings would be ($1,000 X 36%) | $360 |
| your interest earnings would be ($1,000 X 4% X 25 years) | $1,000 |
| for a total of | $1,360 |
In this example, paying down the mortgage is the better option.
You may ask “What about the taxes on the RRSP?” Yes, there are taxes to be paid but the tax payment may be 30, 40 or 50 years from now. But the value of those future tax dollars is very small today.
“What about the size of the mortgage, does that matter?” Generally not. The size of the mortgage is only important if the lump sum payment is more than 10% of the mortgage. If it is more than 10% then the number of years of interest savings would be reduced.
Example #2: let’s say you have a mortgage of $70,000 at 6% that will be paid off in 15 years. You are in the second tax bracket so any tax deductions are worth 30.5% in tax savings and can get a 4% return on you RRSP investment.
| If you pay an extra $1,000 against the mortgage, your interest savings would be ($1,000 X 6% X 15 years). | $900 |
| A $1,000 RRSP contribution is worth in tax savings | $305 |
| and of investment return ($1,000 X 4% X 15 years) | $600 |
| for a total of | $905 |
In this example, making your RRSP contribution makes slightly more sense.
Example #3: let’s assume you have a mortgage of $50,000 at 6% with 10 years to go. You can get a 4% return on your RRSP but you are in the lower tax bracket so that your RRSP contribution is worth 25% in tax savings.
| An extra payment of $1,000 against the mortgage is worth ($1,000 X 8% X 10 years). | $600 |
| The $1,000 RRSP contribution is worth a total of ($1,000 X 25% + $1,000 X 4% X 10 years). | $650 |
In this example, the RRSP contribution is slightly better.
Can we make any rules of thumb from these examples?
It would seem that:
Apart from the above conclusions, the best scenario is to set up the mortgage repayment monthly or biweekly initially for 15 years, then make maximum RRSP contributions before making any extra payments against the mortgage. Once you are making your maximum RRSP contribution, then you can use the tax refund to pay down the mortgage.