Save or pay down the mortgage? Rising interest rates are changing the math
If you have a little extra cash to throw around, is it better to take a bite out of your mortgage debt or fatten up your retirement savings?
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That’s the eternal dilemma that faces many Canadians around this time of the year, when they have to make a decision about how much money they should put into their Registered Retirement Savings Plan (RRSP) before the March 1 deadline for getting a tax refund for the prior tax year.
And if mortgage vs. RRSP wasn’t hard enough to tackle, the introduction of Tax-Free Savings Accounts (TFSAs) in 2009 has thrown a third option into the mix.
The good news here is that you can’t really go wrong whatever you choose. Debating the merits of a mortgage payment booster against those of feeding cash into an RRSP or TFSA is a bit like splitting hairs about the health advantages of broccoli vs. cauliflower.
Still, walking through a concrete example will highlight some parameters to help make your decision.
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Meet Joe and Jane Canuck
Joe and Jane Canuck are two imaginary Canadians and the protagonists of our made-up personal finance scenario (if you’ve been reading our Money123 personal finance series, you’re well acquainted with them by now). In this example, Joe and Jane are a young couple who just bought a $450,000 house with a 10 per cent down payment. Jane makes $60,000 a year and Joe $30,000 for a combined annual income of $90,000. They have a typical fixed-rate mortgage at 3 per cent interest that is locked in for 5 years with a 25-year amortization. And they plan to retire at 65.
If the Canucks had $5,000 in savings to throw at their mortgage or invest, what should they do?
For the answer, we turned to Jason Heath, managing director at Thornhill, Ont.-based Objective Financial Partners, a fee-only financial planning firm.
The math for Joe and Jane is different, depending on whether we’re looking at a short-term or long-term scenario.
WATCH: Why RRSPs aren’t for everyone
Joe and Jane’s calculation this year
If Joe and Jane used the $5,000 to reduce their mortgage principal, they would be saving 3 per cent in interest, which is a bit like earning a 3 per cent guaranteed rate of return.
However, Heath noted, if the Canucks’ TFSA investments are earning more than a 3 per cent annual return, they would probably get more bang for their $5,000 by putting their money there.
As a third option, they could invest the $5,000 in their RRSP. If their RRSP investments earn more than a 3 per cent annual return, they not only come out ahead compared to repaying their mortgage, they also get a tax refund of between 19 per cent and 28 per cent, assuming they have no other tax deductions to claim, said Heath. The actual size of the RRSP refund would also depend on their province of residence and whether Joe or Jane makes the contribution.
“So over a one-year period, if the Canucks think they can earn a higher investment return than their mortgage interest rate, the RRSP results in the biggest increase in their net worth,” Heath said.
WATCH: When it comes to saving for retirement, starting early pays off
But what if Joe and Jane had an extra $5,000 every year?
When you look at the math from a long-run perspective, there are a few more things to take into account.
1. Interest rates are rising
Joe and Jane’s mortgage rate likely won’t stay 3 per cent. The Bank of Canada, the U.S. Federal Reserve and other central banks around the world are slowly hiking their interest rates, which means borrowing money is getting more expensive.
Now, it is unlikely that someone like the Canucks will every face the double-digit mortgage rates of the 1980s. But their rate could very well rise to 5 per cent in the future.
“Posted 5-year fixed rates have been around 5 per cent over the past 10 years, 6 per cent over the past 20 and 7.5 per cent over the past 30 years. Young people like the Canucks may not appreciate how abnormally and temporarily low that interest rates are right now,” Heath said.
On that basis, they would need to be earning a return of more than 5 per cent on their TFSA to be better off investing rather than repaying their mortgage. If they were saving in an RRSP, the bar would be a little lower – say around 4 per cent – because they would also get the tax refund.
2. RRSP money is eventually subject to tax
Joe and Jane also need to keep in mind that money they put into an RRSP will be taxable when they take funds out. Withdrawals from a TFSA, on the other hand, are tax free.
The tax advantages of using an RRSP are greatest if you’re in a high tax bracket when making contributions (think: bigger RRSP refund) and in a relatively low tax bracket in retirement, when you’re taking money out (think: smaller taxes on your withdrawals). Also, if you’re reinvesting your tax refund into your RRSP, the longer the time between contributing and withdrawing, the longer your money will have to grow tax-free.
Assuming a 5 per cent mortgage rate and 5 per cent annual return on RRSP investments, if the Canucks saved their $5,000 into RRSPa every year, they would end up with nest egg of $508,415 at age 65 and and an outstanding balance of $14,842 on their mortgage.
If they put that money toward the mortgage, by age 54 they would have paid off their mortgage, but have no retirement savings. They could then focus on their RRSPs, using the $5,000 a year, along with the money freed up by the absence of mortgage payments, to quickly build up a nest egg. By age 65 they would have an RRSP balance of $527,509.
For Joe and Jane, rising interest rates tilt the balance slightly in favour of debt repayment compared to investing in an RRSP.
Takeaways from Joe and Jane’s story
In our example, Joe and Jane are so-called moderate risk investors. We assumed their retirement portfolio is equally split between stocks and less risky investments like bonds and guaranteed investment certificates (GICs).
If you’re a risk averse investor, paying down your mortgage, which offers a guaranteed payoff, may look like a no-brainer.
On the other hand, aggressive investors, who don’t lose any sleep over having most of their investments in stocks, would probably be better off investing. “Stock market returns in recent years have been good,” Heath noted.
The Toronto Stock Exchange returned 9 per cent in 2017, including dividends. The S&P 500 returned 13 per cent in Canadian dollars, including dividends. And global stocks, as represented by the MSCI World Index, returned 15 per cent in Canadian dollars including dividends.
For moderate investors, the pendulum may swing more toward RRSPs at higher income levels, which yields a bigger tax refund, Heath said.
Some important caveats
There are a few more important asterisks attached to our Joe and Jane scenario.
First, our example is about mortgages, which generally come with low interest rates in Canada. Even at 5 per cent, the Canucks’ borrowing costs would be far smaller than if they had, say, a large credit card balance.
“If someone has high interest-rate debt, I’d pay that down first and foremost before investing,” Heath said.
On the other hand, if Joe or Jane were lucky enough to have a group RRSP or pension plan that includes a company matching contribution, “that would definitely tilt things in favour of this being the best long-term option over a personal RRSP, a TFSA or debt repayment,” Heath noted.
Finally, if the Canucks were owners of an incorporated small business, they would have the option to save in their corporation instead of contributing to their RRSP or paying down debt.
“The point is, there’s no one size fits all answer here,” Heath said.
Hopefully, Joe and Jane gave you an idea of what to look for to find the answer that fits you.
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