Great news! It’s been a year since my article “How Stick to Your 2014 Financial Resolution” and it’s paid off. You have managed to save some money by sticking to you budget. So what are you going to do with that extra cash? If your mortgage allows prepayment, you might be considering putting it toward paying down your principal. This would seem to make sense because the interest on your mortgage is not tax deductible. But what about contributing the extra cash to your RRSP (if you haven’t already contributed the maximum amount every year)? As with most things, this choice will depend on your personal situation.
Doing the Math
With the low mortgage rates these days, and potentially much higher rates of return on RRSP investments, for most people, contributing additional amounts to their RRSP makes the most sense. The best way to demonstrate this is by comparing the tax situation for each of the alternatives. So, let’s assume you have managed to save an extra $1000 and you are in a 40% tax bracket:
- A contribution to your RRSP is 100% deductible from your gross taxable income, and the returns on your RRSP compound and grow tax deferred. In this case, because of your tax bracket, every dollar you contribute to your RRSP you would save $.40. As a result, a $1000 contribution to your RRSP means that, after tax, you saved $400 (40% x $1000).
- If you pay down your mortgage by $1000, you save interest. Assuming your mortgage interest rate is 3%, you will have saved $.03 on every dollar. After your prepayment you will have saved $30 (3% x $1000).
Naturally, if you reduce the principal of your mortgage, you will be paying less interest over the term of the mortgage. However, the tax deferred gains earned on the $1000 contribution to your RRSP will usually more than offset the total interest saved by paying down your mortgage principal. Paying down a home mortgage makes sense for people who are in a very low tax bracket, because contributions to their RRSP would not save that much. Given that the lowest federal tax rate is approximately 20%, and mortgage rates are at a historical low, it usually make sense to put the extra cash toward your RRSP.
Having stated the general rule, there are situations where you might consider putting your extra cash toward paying down your mortgage. For example, the closer you are to retirement, the more sense it might make to pay down the mortgage to that you retire with as little, or ideally, no debt at all. The closer you are to retirement the shorter the time the money will be in your RRSP and as a result the less it will grow. Another situation where it might make more sense to pay down your mortgage is if your are contemplating moving up to a more expensive home in the future. By paying down your mortgage you will be increasing the equity in your current home, and as a result, helping fund your new more expensive home.
It’s a Win/Win
If you decide to put the extra cash into your RRSP, come tax time next year, you may find that you are getting a refund of taxes paid. When the refund cheque arrives why not consider using it to pay down the principal on the mortgage instead of the large flat screen TV you’ve had your eye on. Even better yet, consider putting the refund cheques over several years into a TFSA. The earnings on the TFSA will compound tax free over that time period and you could put the amount received from the tax refunds against the mortgage and the tax free earnings from the TFSA investment towards a luxury item of your choice. As you can see, this would create a win/win situation. Using this illustration and applying it to your personal situation, you will be able to build up your RRSP and you will have also reduced your mortgage principal. Congratulations on sticking to your Financial New Year’s Resolution! You’re now on your way to being mortgage free and building a financial cushion for retirement.