Mortgage or RRSPs?

You’ve worked out a budget and, by sticking to it, have some extra money to play with at the end of each month.

What makes more sense – investing in your RRSPs or pay down your mortgage?

This question is a common one among Canadians and the right answer is never that black and white. To help you make the decision for yourself, let’s look at the pros and cons of each strategy.

Putting this extra income against your mortgage will certainly help you get mortgage free (and debt free) much more quickly.

Each regular mortgage payment you make is a combination of interest owing and capital reduction but in the early years of your mortgage especially, the vast majority is going to interest.

Any “over contribution” is going entirely against the capital and cuts the length of time and overall interest paid dramatically.

For a typical mortgage with a 30-year amortization, one extra payment per year could knock approximately five years off the repayment schedule and 15-20 per cent less interest would be paid.

In addition, the extra payments against your mortgage increase in overall value each time interest rates go up and there is no risk involved with this financial strategy.

Sounds like we already have a winner, right?

There is however a strong case to be made for investing the extra amount in your RRSP as well.

If you take this spare income and put it into an RRSP account instead, not only will that money grow “tax deferred” each year until you need it, you will also receive a tax credit for the contribution amount.

This credit can result in a nice big refund come tax time.

The key here is making sure that you use that refund wisely – it needs to be put back into your investment account to make real sense instead of looking at it like a windfall and spending it.

If you’re opting for this route, the many years of compounding in your investments can build up a sizeable nest egg ready to fund your retirement at about the same time your house is mortgage free.

If you’re mortgage is locked in at a great rate around three per cent, tax deferred growth in your investment account at six per cent each year looks like the smarter choice.

But unfortunately, many people don’t get a consistent solid rate of return.

Far too many people invest in the wrong areas, take too little or too much risk or allow fear and greed to force them in and out of the markets at all the wrong times.

These behaviours produce substantially lower returns and then the strategy of RRSPs over extra mortgage payments doesn’t work anymore.

But if you do get regular growth in your RRSPs by investing them properly and add the tax refund into that equation for further compounding, the RRSP option makes great sense and should put you farther ahead.

Like most things however, there is no right answer for everyone and the risks of both choices need to be considered as well. Long term rates of return on your investments and the mortgage rates you’ll be paying down the road are not guaranteed, and you need to evaluate the potential pitfalls of each choice.   

So which plan makes sense for you?

You should consider your personal situation, risk comfort and debt loads.

If you’re carrying high interest debt on a credit card or other loan, most would agree that needs to be wiped clean first. Once you’re down to only the low interest debt, a blended strategy may be the best solution.

You might take half of the extra income and put it towards each goal or you may decide to put the extra funds into an RRSP and then put the tax refund against the mortgage each year.

Everyone’s situation is different and should be reviewed properly by a Certified Financial Planner professional to create a plan that’s right for you.

Regardless of which of these options you choose, the good news is that you’re working towards a stronger financial future and a stress-free retirement! 

This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.