To Be or Not to Be – (or which is better, pay-off the mortgage or buy an RRSP?)

Lee and Daphne are asking this very question – which is better for them? They are aware of the huge interest cost on their mortgage but also would like to be able to retire in their late 50s or early 60s. Can they do both at the same time or must they choose?

Through diligent saving before they purchased their condo, their mortgage is only $150,000. They are able to afford higher-than-normal payments so decided on a 20 year term at a fixed rate of 5.0%. Over 20 years, they will pay about $87,000 in interest, assuming rates don’t change of course. If they decide to make a principal payment of $6,000 on each mortgage anniversary, they would pay it off in 11 years and reduce their interest cost to about $46,000. In theory, they would then begin contributing that same $6,000 to their RRSPs after the mortgage was paid. But is this the best option?

They are both 30 and by waiting until age 41 to start their RRSP contributions, and assuming they are able to obtain a consistent 7.0% rate of return each and every year up to age 60, they would accumulate about $230,000. Really a very modest amount. At current rates that could pay them a lifetime income of about $1,300 per month. Even including OAS and CPP at current maximum rates, and applying the effects of inflation for 30 years up to retirement and beyond, this is not going to be much of a lifestyle.

So let’s examine this more closely. To pay down their mortgage by $6,000 annually, this young couple has to earn just over $9,100 before taxes (BC rates are used for 2013). If they made $9,100 annual deposits to RRSPs after the mortgage is paid, and using the same 7.0% interest assumption, they could have nearly $350,000 at age 60 – which could mean a monthly income of about $2,000, again based on current rates. Better – but not by very much.

So, by doing some reverse math, if the agree to pay off the mortgage in 15 years and starting with $9,100 of pre-tax earnings, they could deposit $6,800 into their RRSPs every year starting now. The estimated tax savings (in BC at 2013 rates) would be about $2,300. This $2,300 is then used as the annual prepayment on their mortgage. The mortgage would then be paid in full after 15 years with interest paid now being about $64,000. By putting $6,800 per year into RRSPs now and increasing it to $9,100 when the mortgage is done, they would accumulate nearly $710,000 at age 60! At current rates, this would provide a lifetime income of nearly $4,100 per month!

To summarise, their choices come down to 3:

a) Eliminate the mortgage in 11 years by making $6,000 annual principal payments then put the $6,000 into RRSPs each year until age 60. This reduces total mortgage interest to $46,000 and has an estimated total RRSP savings of $230,000 and an income of about $1,300 per month at age 60.

b) Pay off the mortgage in 11 years and then start RRSP deposits of $9,100 each year until age 60. The mortgage interest still totals $46,000 but their RRSP totals $350,000 and a potential lifetime income of $2,000 per month. Better than the first choice, but they can still do better.

c) Finally, they could decide to clear the mortgage in 15 years by contributing $6,800 to RRSPs each year and applying the tax savings of $2,300 to the mortgage principal. When the mortgage is gone, they then increase their RRSP deposits to $9,100 per year. Mortgage interest will total about $64,000, but their RRSPs can grow to $710,000 and generate about $4,100 per month.

Time to think things through – Lee and Daphne decided that choice c) gives them the best of both worlds. While option c) does result in higher interest paid on the mortgage and extends the payment period from 11 to 15 years, there is a very significant difference in both their RRSP savings and potential lifetime income. This does require they pay about $18,000 more in interest but their RRSP total more than TRIPLES – increasing by $480,000 and their retirement income goes from $1,300 per month to $4,000 per month.

Doesn’t it make sense to do this same series of calculations on your mortgage? Happy crunching!

Ian Whiting

Ian R. Whiting CD, CFP, CLU, CH.F.C., FLMI (FS), ACS, AIAA, AALU With more than 40-years of experience in the industry, Ian has qualified 3 times for MDRT, completed LUATC in 1979, the LUAC Financial Planning Skills Course and attended numerous Schools in Agency Management and Sales Management through LIMRA. He obtained his CLU in 1987 while also completed his IFIC qualification and completed his Fellowship in the Life Management Institute with a specialty in Financial Services in 1988. In 1989, he completed qualifications for his Chartered Financial Consultant designation. In 1992, he qualified as an Associate of the Academy of Life Underwriters (Head Office underwriter qualification) and in 1993 he completed his Associate, Customer Service designation program through LOMA. In 1997, he qualified as a CFP and also completed his courses and exams to obtain the Associate, Insurance Agency Administration designation. In 1999, he completed the study and examinations to qualify as a Trading Officer, Partner and Director for Mutual Funds with the BC Securities Commission. As a result, he is also qualified as both a Branch Compliance Manager and Head Office/Provincial Compliance Officer. He served for nearly 18 years with the Canadian Forces (Air) Reserve (reaching the rank of Captain) primarily working with Air Cadets and was award the Canadian Forces Decoration (CD) in 1982. Long known as a maverick and forward thinker in the financial services world, Ian enjoys the challenge of learning new material and planning for the future evolution of his chosen profession.