A New Look At The RRSP vs. Mortgage Debate
Most debates over whether to pay down the mortgage or contribute to an RRSP boil down to one thing. If the interest rate on your mortgage is less than the expected return of the investments in your RRSP, then go with the RRSP. When rates are higher, then paying down the mortgage makes more sense.
RRSP vs. Mortgage
But there’s another factor to consider in the RRSP vs. mortgage debate, and it has to do with emergency funds. What happens if the main breadwinner in your family loses their job? In which scenario do you keep your home: having $100,000 in your RRSP, or having a slightly smaller mortgage and no emergency funds?
Related: On job security and preparing for the worst
Sinking all your free cash flow into the mortgage in hopes to pay it off early can leave you in a tight spot if you become unemployed for a long period of time. And while you can reduce your payments back to the minimum, and even take a mortgage vacation for a few months, your bank still wants its money back.
A healthy RRSP, on the other hand, can help you weather the storm in the event of a long-term income drought. Sure, you’ll pay tax on any withdrawals from your RRSP, but that beats going into debt or losing your home.
The risk of going all-in with your mortgage
Let’s say the Jackson family bought a home worth $400,000 and used all their savings – $80,000 – for a down payment. They’ve diligently paid down the mortgage, doubling their monthly payments and adding a $5,000 lump sum at the end of every year.
Related: How to pay off your mortgage faster
After five years they’ve paid off $165,000 of the principal and owe just $155,000 on the house. They’ll be completely mortgage free in another four years.
The Jackson’s do this at the expense of saving for retirement, thinking that once the mortgage is paid off they’ll start putting money into RRSPs. Joe works full-time as a consultant and Janet stays home with their two boys, ages 5 and 2.
When Joe loses his job, the family has no emergency income buffer to see them through the tough times. After a month, Joe goes to the bank to apply for a line of credit, but the bank needs his recent employment history and pay stubs from the last two months in order to set it up. Sadly, the bank turns down his loan application.
Even though the Jackson’s are sitting on nearly $250,000 in home equity, there’s nothing they can do to unlock the funds, short of selling the house.
Using RRSPs as an income buffer
Now let’s go back in time to when the Jackson’s bought their house. Instead of putting every last dime into their mortgage, they add just $250 per month to their $1,500 minimum mortgage payment. That frees-up $20,000 per year to invest in their RRSP.
Related: How an RRSP loan turned my $12,000 contribution into $20,000
After five years, the Jackson’s have over $112,000 in their RRSPs and they’re still on track to pay off their mortgage in a reasonable 20-year time frame. When Joe gets laid off from his job, he’s able to draw from his substantial RRSP portfolio instead of turning to debt or selling the house to get by.
The family has expenses of just under $5,000 per month. Joe’s job search lasts five months, so he needs $24,500 from his RRSP to pay the bills and put food on the table.
If you withdraw more than $15,000 from your RRSP the bank holds back 30 percent to pay the government on your behalf (withholding tax). That means Joe has to withdraw $35,000 from his RRSP in order to end up with the $24,500 he needs.
Related: Using your nest egg early may cost you
Final thoughts
Even though it may feel like the prudent thing to do is pay off your mortgage as quickly as possible, putting all your eggs into one basket – in this case, your house – can actually be a risky proposition.
In the last scenario, Joe ends up back on his feet and still has nearly $80,000 saved in RRSPs. The mortgage continues to get paid, and the Jackson’s aren’t forced to sell their house to get at the equity.
Related: What does pasta have to do with RRSPs?
When in doubt, you can’t go wrong with the tried and true Canadian approach of making an RRSP contribution and then using the refund to pay down the mortgage.
How about applying for a line of credit while you still have an occupation? That way you’ll still have access to an emergency fund while solely paying down your mortgage.
You could do that, but I like the idea of being more diversified. I don’t like having all my eggs in one basket, no matter which basket.
I tend to agree with Brian on this one.
I think you’re advice of diversifying and not putting all your extra money on the mortgage makes sense.
However, anyone who is going to think through this strategy and make sure they have emergency funds available in their emergency fund, their RRSP, or elsewhere is going to plan ahead and get a line of credit while their credit and employment situation are good.
Always apply for credit when you don’t need it and use it responsibly, so you have it when you do.
“A bank is a place that will lend you money if you can prove that you don’t need it.” – Bob Hope.
Unless you’re a student, then they’re all too happy to give you a student line of credit that has you paying interest all along…
I’m a little cynical about student loans 😉
@Brian – that would make sense, however I find that most people are overconfident in their job security and might not think that far ahead.
We opened one shortly after buying a house as an e-fund. We figured we needed a bigger one than before, and we didn’t have a bunch of cash sitting in an account to eventually be used as a downpayment anymore.
That was recommended to us when we bought our house so we did just that. We’ve never used it but it’s there just in case. Good point Brian.
Ha. Good point! I don’t have a mortgage yet, but I have had the debate whether to contribute more to my TFSA and RRSP or keep building my downpayment fund. (I have the 20% needed, but the time isn’t right to buy yet.)
I ended up opting with the TFSA and RRSP route because I would feel comfortable putting this long-term savings into higher earning vehicles — rather than putting more money into a lower-earning but more liquid vehicle to be taken out in a year or two.
Hi Beth, in your case the TFSA is more flexible and likely makes the most sense, especially if you might pull the trigger and buy a house soon.
Interesting point. I had wondered about putting more into my RRSP because then I could use it for the downpayment if I needed (first time buyer).
I’m also have a car debate. I could pay cash for my next car, but the interest rate is so low that I would be further ahead saving or investing the money instead. I like being debt-free though!
The mortgage product that we have from the Bank of Montreal has an attached line of credit. As the principal is paid down on the mortgage the available funds on the line of credit go up by the same amount. This way all the extra money we put on the mortgage is always accessible. The down side of course is that you need to be disciplined and not using the line of credit unless it is really necessary. Despite this, we still contribute to the RRSP first and then use the tax refund and anything else we can save to pay down the mortgage. We set an annual goal of how much we want to pay down on the mortgage at the beginning. To date, 3 years into the mortgage, we are only off by a few hundred dollars.
Good work, Diane! It’s nice to have the flexibility of a line of credit, but you’re right, you need the discipline to avoid using it as an ATM.
Your argument makes some sense, but I think the real way to reduce risk in this case is to not go $400,000 into debt in the first place. There’s nothing wrong with renting when the numbers make sense.
@Michael James – You don’t think a couple who has the ability to save $23,000 per year can afford a $320,000 mortgage?
They can save $23k/year except in years when one of them loses a job, or they need a new roof, furnace, windows, or flooring.
All that aside, though, why would you want to embark on multiple decades of scrimping when you don’t have to? Too many people stretch too far, buying too much home and filling it with too much stuff. I came close to buying a 25% larger home 20 years ago, and I’m glad I didn’t. Becoming debt-free while you’re still young is fantastic.
Fair point. The fact is, however, that something like 70% of households own their home and so rather than wagging my finger at them I thought I’d share a strategy that might actually be useful to their real life situation.
I see this article as a parable to illustrate that you can choose to invest in ways that can be liquidated easily or in others where is takes great difficulty.
In real life, however, I would question why anyone with a single income for a family of 4 and a huge mortgage wouldn’t have an emergency fund for job loss/major illness etc. Families I know living in this scenario have topped up TFSAs for both parents to give them at least a $62,000 cushion to live off.
I agree with the comment on getting a line of credit. It’s a good vehicle to leverage if needed. As emergency before selling the home, the family above could always apply for a second mortgage with no problem because they have lots of equity. Income is not a major requirement (in most cases) when it comes to second mortgages.
I also agree with putting the money elsewhere and not pay down the mortgage aggressively if the rates are low. Diversifying with RRSPs, RESPs TFSA, a rental property, life insurance, etc is a better strategy. Regardless if one’s mortgage is $165K or $400K, the home still appreciates at the current market value. Why lock up you money within those 4 walls? Leverage the low rates and grow your investment portfolio.
I would rather own than rent anytime. Of course one needs to make enough income to support the mortgage. In this scenario, the family can easily pay the mortgage when employed.
I don’t think a $400K mortgage is big at all. Then again I live in Burnaby BC so housing prices are high here. My mortgage started off at $780K+…lol. Interest was only 2.89% on a 5yr fixed so that’s cheap money. The house has appreciated over $100K since I bought it 2yrs ago so I have made more than the interest I have paid. If I were to rent, that’s like 100% interest where I wouldn’t see any of that back and it’s the landlord that gets to take advantage of the home’s appreciation.
Darryl I agree, I’m from Victoria,BC with similar housing costs. I always cringe when I see the lower prices paid by others in Alberta, Ontario etc although I keep reminding myself we do it for the “better” weather!
I’m surprised that the author doesn’t mention buying RRSP’s and using the tax refund to pay down the principal. Pretty standard technique. If you have the ability to handle the cashflow and the risk and in this case it appears to be the case, an RRSP top-up loan combined with paying down the mortgage principle could be a good option.
Hi Peter, I did say that, right here – “When in doubt, you can’t go wrong with the tried and true Canadian approach of making an RRSP contribution and then using the refund to pay down the mortgage.”
I suggest taking a bit wider view by looking at your entire balance sheet – all assets and all liabilities. There’s no use agonizing over “mtg vs RRSP” if you are carrying credit card balances at 20%-30% p.a.
I struggle with the RRSP contribution and then using the refund to pay down the mortgage. This is because not reinvesting the RRSP-generated refund, you’re missing one of the most critical elements/benefits of the RRSP account.
Personally, I prefer to contribute to the RRSP throughout the year and reinvest most of the refund every year – thereby maxing out the account benefits.
As for paying down debt, this is always a good move even if your mortgage rate is 3%.
I would think most Canadians would benefit doing a bit of both – kill the debt and contribute to the RRSP at the same time. Most investment portfolios are a balancing act and Canadians are best served learning, practicing and becoming experts of each.
Mark
I think it’s all about having a multi-tiered approach. We paid off our mortgage and there were several things going on. One, as we paid it off, we were able to reduce the payment below the original payments. We did so to free up cash flow to pay for our wedding, for example. The flexibility our mortgage provided (which I understand not everyone has), made it a less risky plan. If we had needed to, we could have rented out a room at a rate that would have covered most of our operating costs and part of the smaller mortgage payment. We both work, and have some small side income streams. Plus, we had reasonable RRSP contributions and matches at work, so we could have withdrawn our own contributions, if we weren’t living on low-rate credit anyway. Now that the mortgage is paid off, we can survive on two minimum wage jobs, should we ever need to.
We just paid our mortgage in full this May just 5 years after buying it. We are both under 40 years of age and no kids. Some would say we have lots of time to invest but we still didn’t sink it all into the mortgage.
Sure we could have piled more cash into retirement but we chose to balance that savings. We didn’t use all of our cash though as we still have over $80,000 waiting to be used up however that will start to go towards more investments, renovations, emergency savings etc. I would certainly think about the emergency fund, paying into retirement and paying down the mortgage. Focusing just on one aspect can be like putting all your eggs in one basket. Yes, you are right anything could happen and selling the house might be the only solution if all the homeowners cash is in the home. That might be a risk though that some are willing to take. Personal decision in the end I suppose. Great post.
Considering that rrsp reduce taxable income it may be even more benefit to parents to contribute to rrsp over the mortgage due to the increase in (tax free) child benefit payments it provides.
Am I correct that this is the case?
Hi Jamie, you’re absolutely right. In fact, I noticed that when trying to calculate our new Child Benefit payments for this year. My RRSP contributions lowered our net income, which meant a lower “phase out” and higher monthly payments.