It’s an age-old financial dilemma. Should you use your extra savings to pay down the mortgage or contribute to your RRSP? A simple answer is to compare the expected return from your investments to the interest rate on your mortgage.
In today’s low rate environment, where mortgage rates sit well below 3 percent, many assume their investments will easily come out ahead. If rates tick higher, the mortgage pay down starts to make 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 savings.
What happens if the main breadwinner in the family loses his or her job? Who is more secure: the family that has $100,000 saved inside their RRSP, or the family that has a smaller mortgage but no savings?
Sinking all your free cash flow into the mortgage in hopes to pay it off early can leave you in a tight spot should 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 balance, 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.
Let’s say a 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 each year.
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.
This family prioritizes their mortgage at the expense of saving for retirement, thinking that once the mortgage is paid off they’ll start putting money into RRSPs.
He works full-time as a sales manager and she stays home with their two kids, ages 5 and 2.
When he loses his job, the family has no emergency income buffer to see them through the difficult times. After a month, he 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 this family has nearly $250,000 in home equity, there’s nothing they can do to unlock the funds, short of selling the house.
Let’s go back to when the family first bought their home. This time, instead of putting every last dime into their mortgage, they add just $250 per month to their $1,500 minimum mortgage payment. This approach frees-up $20,000 per year to invest in their RRSP.
After five years they have over $112,000 saved in their RRSPs and they’re still on track to pay off their mortgage in a reasonable 20-year time frame.
When he gets laid off from his job, he’s able to draw from his substantial RRSP portfolio instead of turning to debt or being forced to sell the house.
The family has expenses of just under $5,000 per month, and the job hunt lasts five months. They need to withdraw $24,500 to pay the bills and put food on the table.
When 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 the family has to withdraw $35,000 from their RRSP to end up with the $24,500 needed to cover their expenses.
Even though it might feel like paying off your mortgage as quickly as possible is the most prudent thing to do, it can actually be a riskier move than investing in your RRSP.
In the second scenario, the family ends up back on their feet in a few months and still has nearly $80,000 saved in RRSPs. They continue to make their mortgage payments and won’t be forced to sell their house to get at the equity.
If you still can’t decide whether to prioritize your RRSP or mortgage, you can always go with the tried-and-true Canadian approach of making an RRSP contribution and then using the refund to pay down your mortgage.