Tuesday, February 11, 2014

Pay Down Your Mortgage, or, Invest in an RRSP

I came across an article with this exact title, and after reading it, discovered that I learned nothing. The article never explained which was better. It did however suggest that if you were going to pay off your mortgage before retirement anyway, maybe, and I repeat, maybe, you should invest in the Retirement Savings Plan (RSP), so that you can accumulate savings.
That sounded logical to me, but I needed to do the math.

Let's look at 2 examples and see what the answer is in each case. But, before we do, I'll give away the answer for you types that don't want to see details, because they taught us in consulting school that the first page of any report gives the answer, for the president, and the proof of concept is in the appendix for the accountant to confirm.

SO THE ANSWER IS: If you have 25 years ahead of you on the mortgage, then you are better off paying off the mortgage vs. investing in an RRSP. On the other hand, depending on your taxable income, there is a point in time (in the case below, it's with 13 years left on the mortgage) when you are better off putting the potential mortgage anniversary money into an RRSP and letting the mortgage ride.


CASE 1: TAXPAYER WITH 25 YEARS LEFT ON THE MORTGAGE

Let's use the example of a thritysomething year old parent with an income between $55,000 and $80,000, which after standard deductions most likely puts them in the 31.15% marginal tax rate.
I chose thirtysomething so that, with a 25 year mortgage, as per the article, they would still be earning income during the entire life of the mortgage.
Now, let's say they bought a home with a $600,000 mortgage, and a 3.5% interest rate. And, to make life simpler, let's say the term of the mortgage is 25 years (I know, no chance of that, but, if we assume the rate remains constant for 25 years, we will be making the same assumption about interest earned from the RRSP, so, it's a wash).See below



If so, then their monthly mortgage payments are $2,995.63, as per the RBC bank mortgage calculator.  See below



So, what if the taxpayer has available cash of $10,328 to put against the mortgage. (Why $10,328 because that's the equivalent of $15,000 put against an RRSP after the $4,672 tax saving. We'll get to that calculation later.)

RBC says that if you pay your mortgage down by $10,328 yearly (anniversary payment) for 17.3 years, then, you will have paid off your 25 year mortgage. See below.



So, to recap. A person earning between $55,000 and $80,000 with standard deductions for themselves and kids, will be in the marginal tax bracket of 31.5%. If that person invests $10,328 per year into their $600,000 mortgage, they will own their house in 17.3 years. NO MORE MORTGAGE PAYMENTS.

But, what it they choose rather to invest in an RRSP, you ask. O.K. let's begin.
A person with a $65,000 after standard deductions taxable income, living in Ontario will pay $13,430 in income tax. See below.


Now, if that person contributes $15,000 to an RRSP, they will reduce their taxes owing to $8,758.



That's a reduction of $4,672, which if they were to subtract from the original $15,000 is $10,328, the amount of real dollars we are assuming that this taxpayer has available, either to put into an RRSP or to put against his mortgage.

How much would those savings accumulate in 17 years, see below.



So, on the one side if they put they money against their mortgage for 17.3 years, they are now mortgage free, with a paid off house, but, no savings. On the other hand, if they put money in savings and didn't pay off the house, they would have $263,685 in the bank, BUT, still owe the mortgage company 8 years of payments at $2,995.63 per month which is an additional $339,510.



Why after 17 years do they still owe over 50 percent of the original mortgage, because the first 10 years of the mortgage payment goes almost 100% to paying off the interest, not the principal.

Back to the original question. RRSP vs. Mortgage. In summary, if you invest in your home, and then when the mortgage is paid off, after 17 years, you put $35,948 per year in the bank for 9 years,you will have savings of $339,510 plus interest.

On the other hand, if you don't pay down your mortgage, but rather put $10,328 towards an RRSP, after 17 years you have $268,685 in the bank and still owe the mortgage company $339,510. Looks to me like a no brainer! PAY OFF THE MORTGAGE


CASE 2: SAME TAXPAYER BUT WITH ONLY 13 YEARS LEFT ON THE MORTGAGE

Let's use the same taxpayer, but now, he's fortysomething with only 13 years left on his original 25 year $600,000 mortgage. For the sake of simplicity let's assume he is still in that 31.5 % marginal tax bracket.


So, starting in year 13, let's begin paying off the house with the yearly $10,385 anniversary payment, instead of putting $15,000 into his RRSP. After 8 payments, the mortgage will be paid off by the end of the next year (year 21).



Again, what if we don't put the 8 anniversary payments into the mortgage, but rather, put them into an RRSP. If we look at the savings chart we used before, you will see that the value of our savings after 8 years is $123,789.





And again, what if after 8 years we hadn't put anything into the mortgage, what is 3 years of payments to pay off the mortgage. (Note: we skip year 9 because we pay that in either scenario). At $2,995.63 per month, that's $107,842.68

A HA! In this case, after 8 years of putting money into the RRSP, we actually owe less on our mortgage than the value of our RRSP account, assuming 3.5% interest on our savings and 3.5% mortgage interest rates. So, INVEST IN RRSP AND THE TAX SAVINGS MAKE UP FOR THE EXTRA MORTGAGE PAYMENTS.

The moral of the story: the article was right. RRSP vs. Paying Off the Mortgage, it depends!! 









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