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?
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.
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.
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.
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.