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.