Your mortgage or RRSP: where should you put that extra cash? It’s the financial question of the 21st century and it’s not easy to answer.
The one-size-fits-all solution to this question is to contribute excess cash flow to your RRSP and use the tax refund you get to pay down the principal on your mortgage. This is a good strategy, but it might not be the solution that will get you the most for your hard-earned buck. Let’s look at some of the facts to guide you to the path that’s right for you.
Analyse the numbers
When you break it down, paying down debt offers a guaranteed return. For example, if your mortgage is at three per cent interest, that three per cent is the guaranteed return on every dollar used to pay down your principal.
This is where it’s important to do a side-by-side comparison with your RRSP investment. In situations where an individual’s expected return on his or her RRSP investment exceeds the interest on a mortgage, it may appear more beneficial to invest the money for long-term growth and income.
In this environment of exceptionally low interest rates on mortgages and lending, it’s likely that even if your appetite for risk isn’t that high, you will still earn a better rate investing in your RRSP.
So, it sounds like I’m saying you should prioritize saving in your RRSP, right?
Mortgage or RRSP: Think again
Not quite. At least not if you are in a lower tax bracket now than you expect to be in retirement. In that situation, and contrary to what many people believe, the tax-deferred growth on those pre-tax savings now do not make up for a higher tax bracket down the road.
To know whether you’ll be in a higher tax bracket at retirement, think about your sources of income in retirement. You will likely have some government benefits, including CPP and OAS. Will there be other pension income between you and your spouse? Maybe you’ll have rental income? Or maybe you’ll have received an inheritance or sold a property, and the proceeds will be generating additional investment income and capital gains for you.
However, if you are on a career path where your income is going to grow considerably before you retire, wait to make RRSP contributions in those higher earnings years when the deduction will be worth far more – trust me, you will thank your past self.
The beauty of TFSAs
Regardless of your career trajectory, if you suspect you’ll be in a higher tax bracket when you retire, consider paying down your mortgage or contributing to a Tax Free Savings Account (TFSA) instead of an RRSP.
A TFSA offers tax-free growth, and while you don’t get a tax deduction when contributing, the withdrawals will be tax-free. That tax-free element is especially important if you are in a higher tax bracket after retirement than before.
While people can be at similar life stages, situations are diverse. So when it comes to retirement savings and whether you should put that extra cash into your mortgage or RRSP, varying circumstances require different financial strategies. Talk to a CFP professional before tagging along with any old one-size-fits-all solution.
Updated April 19, 2021. Originally published August 16, 2017.
The views expressed by the author do not necessarily reflect those of All Things Home. This article is provided as a general source of information only and should not be considered as personal investment or legal advice, or a solicitation to buy services. Consult your financial or legal advisor to ensure it’s suitable for your circumstances.