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Conventional wisdom on prepaying the mortgage leads to a less-favourable retirement situation

by Wayne Cheveldayoff, 2004-04-01


The ideal situation for everyone is to have enough money to make the maximum allowable RRSP contribution each year and make the maximum prepayments allowed without penalty on their mortgage.

But few people are lucky enough to be able to do this. Most face a dilemma each year over what to do with any funds they can spare.

The conventional wisdom – promoted by mutual fund-sponsored television ads – is to do both. Put the extra money into the RRSP and then use the income tax refund to pay down the mortgage.

But the numbers tell a different story. The ‘a-little-of-both’ strategy is certainly better than just paying down the mortgage.

But the best strategy by far for those facing this choice is to sock all of the extra funds and tax refunds into the RRSP and leave the mortgage alone.

Adopting this ‘all-RRSP’ approach, it may take you a few more years to pay off your mortgage but you will end up with a much bigger RRSP to fund your retirement needs.

Here’s an example that proves the point.

Jeff, Anthony and Melissa are all 30 years old and are in the 40-per-cent tax bracket. They each have a mortgage of $150,000 and each can save $5,000 a year after they pay their ongoing living expenses. Their annual RRSP contribution limits are $15,500 but they don’t have the resources to contribute the maximum

For all three, it is assumed that the mortgage rate is 5 per cent, the mortgage is amortized over 25 years and the monthly payment is $872.

Also, all RRSP contributions are assumed to compound at an 8-per-cent annual return on investment, which is certainly achievable in today’s investment climate with a diversified portfolio of income trusts.

All their income-savings situations are assumed to remain static to age 65.

Jeff takes the approach of using the $5,000 saved each year to make a prepayment on his mortgage. His ‘all-mortgage’ strategy is in line with what his father always told him, which is to pay the mortgage off as fast as possible. Jeff contributes nothing into an RRSP until the mortgage is paid off, which will happen when he is 44 years old, at which time he will begin annual RRSP contributions of $15,464 ($5,000 savings plus the $872 per month or $10,464 per year he no longer has to pay on his mortgage).

Anthony has seen the TV commercials and decides to do things differently. He contributes the extra $5,000 into an RRSP and uses the income tax refund of $2,000 (based on the 40-per-cent tax rate) to pay down his mortgage. At age 48, he will be mortgage free and, four years after Jeff, he will be able to bump up his RRSP contributions to $15,464 per year.

Melissa also got the TV-ad message but she did some calculations of her own and decided to plow all of her $5,000 savings plus tax refunds into her RRSP (no mortgage prepayment). The total contributed to the RRSP each year is $7,800 ($5,000 savings, plus the $2,000 initial tax refund, plus another $800 in tax refunds based on the extra $2,000 contributions over and above the initial $5,000 contribution). At age 55, her mortgage will be paid off and at that time she, too, will be able to boost her RRSP contributions to $15,464 per year.

When all three get to age 55, Melissa’s ‘all-RRSP’ strategy will be the clear winner. Her mortgage will be paid off and she will have $623,644 in her RRSP.

Anthony’s ‘a-little-of-both’ approach will be runner up. His mortgage will be paid off at age 48 but between then and age 55, he will only be able to accumulate $442,292 in his RRSP.

Jeff’s ‘all-mortgage’ strategy will have the poorest showing. He will pay off his mortgage by age 44 but his RRSP will grow to only $257,000 by age 55.

By age 65, with all three continuing to contribute $15,464 into their RRSPs, the absolute dollar gaps between the strategies will be even larger: Melissa’s RRSP balance will total $1,570,421, Anthony’s $1,178,896 and Jeff’s $779,740.

For those facing the RRSP versus mortgage prepayment choice, this example clearly points to what you should do: Put all your extra money and tax refunds into your RRSP.

It is also important to make sure your RRSP is properly managed to get the maximum return possible. The 8-per-cent return assumed in the example is achievable even in today’s low-interest-rate environment, but not if the money is simply stuffed into a bank savings deposit yielding 2 or 3 per cent and forgotten.

The example also illustrates the point that conventional wisdom is not always right. It pays to question it, to read all you can in books and on the Internet and to perform your own calculations, which are easy to do using the financial calculators provided on various financial sites.

This column, for instance, was triggered by an article on the subject at a website operated by Fiscal Agents (www.fiscalagents.com), a Toronto-area financial services group.

The calculations for the example were performed in less than an hour at one of the many mutual-fund, bank and other financial websites that have online RRSP and mortgage calculators.

There is no need to be a slave to conventional wisdom. Do your own projections based on your own situation.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.

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©2004 Wayne Cheveldayoff