Contribute to RRSP or Pay Down Mortgage?
This might be the most asked personal finance question in Canada: Should you contribute to an RRSP or pay down your mortgage? Most people would lean towards putting money into an RRSP because of the tax credit and the possibility of a higher return.
However, when considering the tax benefits of the RRSP option, some people don’t realize the tax savings related to reducing their mortgage principle.
RRSP Contributions vs. Mortgage Pay Down
First of all, it’s important to understand the tax implications of your decision. There are some advantages to each course of action, so you will have to weigh the situation according to your own situation and what is likely to work for you.
Your mortgage payments are made with after-tax dollars. When you pay down your mortgage, you not only save the interest, but also the taxes on that interest as well. Many people forget that the interest you pay on your mortgage is taxable as well. So, when you pay down your mortgage, you are reducing the amount of money you spend on taxes. Considering your principal and interest, that can add up over time.
On of the arguments in favor of funding the RRSP is the potentially higher return. When you pay off your mortgage, you save a bit on taxes, and you save what you would have paid in interest. An RRSP allows you to earn a return at a higher rate. When you pay off your mortgage early, your return is somewhat capped by the low interest rate. So your savings don’t translate into the same level of return that you could see with the RRSP.
But with that return comes risk. Paying down your mortgage has a guaranteed return, equal to the interest and income tax saved. With the RRSP, you have the potential for loss. You could very well lose overall when you invest in your RRSP. But you do get a tax benefit as well. If you can reap the higher returns, plus the tax benefit, you could come out ahead. But remember that the higher potential returns are, the higher the risk is of loss.
Right now, with the current stock markets and mortgage rates, the arguments either way are magnified. For the pro-RRSP case, stocks are at lower prices, increasing the likelihood of a greater return in the long-term. For the pro-mortgage side, rates are low, so the more you pay on your mortgage principle now, the more interest you’ll save in the future when rates increase.
While you can never be completely sure which choice is best for you, you could do both as a form of diversification. You could contribute to your RRSP and then use the tax credit it provides to pay down your mortgage principle. That’s a strategy that can help you hedge some of your losses, and take advantage of the benefits offered by the RRSP and pay down your mortgage a little bit later.
Run the numbers, and think about what is likely to be best for you. Create a strategy that will boost your financial situation in the long run.
I wrote about a tiny little twist to the last stragedy listed to give a person what I will call “free money.”
Have a read here:
Paying for a house or a retirement plan, could you not have both. If you are paying for a mortgage on a house that you are not struggling with them in realty you should try and pay more into paying off the mortgage. This is a good idea as there will be less interest and as soon as your mortgage is paid off then no more mortgage payments means more money available to you while you are still earning. But there is always the notion of retirement and what money is available when you are no longer earning and have a paid off house.
the past few years I have been maxing out my tfsa then adding to my rsp. I locked in my mortage for 5 years at 3% and it is smallish.
I think you need to take into account how much mortgage you have. If you have a low mortgage in your home and you can manage to pay it out of your income without a problem, you can look at alternative investments for your money.
However, many people took on large mortgages in order to get in to the housing market before it is too late. They hardly have any equity on their home and mortgage payments are high, even with low rates. They should look into paying their mortgage down first, just in case rates start shooting up.
I’m less comfortable with debt than most, so I always try to pay down debt first, before investing.
So in a given year, I’ll max out my TFSA investments, and any extra goes into a lump sum payment against the mortgage principle (my mortgage company lets me do 4 lump sum payments per year).
I’ve never used any RRSP room, but will begin to once the mortgage is gone. My theory here is that since I’m young, I’ll probably (hopefully!) be making more later on in life than I am now, s the tax savings from RRSP’s will have a bigger benefit to me when I’m in a higher tax bracket.
I agree with Tom and the others that paying off the mortgage first is usually better, if you are risk averse. If you don’t mind taking some risk, the RRSP may do better than your mortgage rate. Note that all three of the mortgage, RRSP and TFSA give a tax free investment return.
Tom, those that are going for the RRSP because of the current tax credit have been led down the garden path. If you do the math, you will see that the current RRSP “tax refund” is a fake, and illusion.
For example, assuming a 30% tax bracket, a $10,000 RRSP contribution will return a $3,000 “tax refund”. Note that the $10,000 RRSP contribution only actually cost you $7,000 out of pocket due to the $3,000 refund. Note also that the $10,000 RRSP investment is only WORTH $7,000, as that is what you will have left if you withdraw the ten and pay three in tax. Looks like $10,000, but $7,000 in, $7,000 out, its only $7,000.
Consider that you might just as well put $7,000 in your TFSA or your mortgage prepayment. You do not have to wait for your $3,000 “refund”, as you did not have to put out the extra money to “buy” the tax refund in the first place, as you did with the RRSP. Say several years down the road, your $10,000 RRSP has tripled to $30,000. Invested in the same manner, your $7,000 TFSA would be at $21,000. If you need to spend it, your TFSA is worth $21,000 in real dollars, whereas your RRSP is worth $30,000 less $9,000 of tax equals $21,000 in real dollars. So where is the RRSP advantage? Lets make this very clear: to get the RRSP “refund” you had to put out an extra $3,000 in the first place. The so called RRSP related tax “refund” is an illusion.
If you are going with the RRSP, go because of the long term tax deferral, forget about the current refund incentive because it counts for nothing.