Thursday, August 4, 2011

Pay down mortgage vs. RRSP - which should come first?

If you have received a salary increase, should you use your extra cash flow to pay down your mortgage faster or to contribute to your RRSP?

It depends on whether your RRSP growth rate can exceed your mortgage interest rate.

You can use an online calculator to project and compare the size of your RRSP at a particular future end date, such as age 65, under two competing scenarios. Suppose, for example, that you are age 40 with a mortgage of $200,000 and a five per cent interest rate. In both scenarios, keep the total amount of your mortgage payments plus RRSP contributions constant at $2,116 per month. That's how much is required to completely pay off your mortgage in 10 years.

In the first scenario, you quickly pay down debt. Make your $2,116 monthly mortgage payments over 10 years and no RRSP contributions. Then, once you're debt-free at 50, you would start depositing the same $2,116 amount to your RRSP monthly for the 15 years to 65.

In the second scenario, you favour RRSP contributions. You'd make only the $1,163 payments required to pay off your mortgage over 25 years. At the same time, you deposit the $953 (the difference between $2,116 and $1,163) monthly to your RRSP over the whole 25-year time frame.

Under both scenarios, you can accumulate an RRSP worth over $500,000 by 65. But the second scenario, with the early start to the RRSP, can give you a significantly larger RRSP at 65 provided that your RRSP growth rate beats your mortgage interest rate.

In the first scenario, you need discipline to make large, voluntary contributions to your RRSP after your mortgage is paid off at 50. Resist the temptation to trade up to a fancier home requiring you to make new mortgage payments.

How do today's mortgage interest rates compare to the average RRSP growth rates?

Mortgage rates are currently around five per cent - or lower for short terms. Mortgage rates could conceivably remain this low for a couple of decades mainly because of the huge age wave of 10 million baby boomers retiring.

When you combine a growing supply of cash to lend with declining demand by borrowers, it is reasonable to expect that interest rates could stay low for several decades.

The question is: Can your RRSP growth rate beat a five-per-cent mortgage rate? If the RRSP growth rate you expect exceeds the mortgage interest rate, you would have more incentive to begin RRSP contributions before paying off your mortgage.

A risk-averse investor probably has an RRSP growth rate below five per cent. Of course, an RRSP investor can beat five per cent by hiring the best investment managers and doing no market timing.

However, generally, unless your RRSP returns exceed the interest rate on your mortgage, it is prudent to pay down your mortgage first. Paying down debt is a risk-free investment.

Terry McBride is a member of Advocis (The Financial Advisors Association of Canada). This article provides general information and should not be considered personal investment or tax planning advice.
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