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Companion Advisor: Retirement
Many clients face a dilemma during their peak earning
years. They know they should maximize their RRSPs,
but they are also highly motivated to repay their mortgage -- the biggest
debt of their lives.
RRSP contribution or mortgage repayment?
We tell them not to wait until the house is totally paid off before starting
their RRSPs! You will lose so many years of potential savings, that it will
be virtually impossible to catch up. Let me prove this with the following
"Bill Jones" is 30 years old and in the 40% tax bracket. He has
a $150,000 mortgage,
which he's repaying at $1,170 monthly, based on a 25-year amortization
period and 8% interest. He is able to save $3,500 annually, and opts
to put this entire sum into his mortgage. He plans to start contributing
to his RRSP once his house is paid off.
"Mary Smith" starts off in the exact same position. She too is
30, and her $150,000 mortgage has the same terms and repayment schedule
as Bill's. But she opts to put her annual savings of $3,500 into her RRSP
instead of prepaying her mortgage. In her 40% tax bracket, this RRSP contribution
entitles her to a $1,400 tax refund, which she does put against her mortgage.
Over the years, her RRSP return averages 12% annually.
Here's how their decisions play out over time.
Bill will pay down his mortgage in 16 years. Because he got no deduction
for RRSP contributions over that 16-year period, he will have paid $22,400
in taxes that Mary avoided. At age 46, he is finally ready to start his
RRSP: he will replace his monthly $1,170 mortgage repayment with a monthly
$1,170 RRSP contribution, which will maximize his annual contribution.
At this point in time, Mary is also 46. She owes almost $47,000 on her house
and is four years away from discharging
her mortgage. Her RRSP has grown to almost $170,000. She plans to continue
her annual $3,500 RRSP contribution for the next four years, and continue
applying her $1,400 tax refund against her mortgage. At that point, she
too will replace her $1,170 monthly mortgage repayment with a monthly $1,170
Now let's see where they're at when they turn 65. Both of them have paid-off
homes of equivalent value. But Bill's RRSP is worth about $765,000, while
Mary has a plan worth almost $3.5 million. Mary's 16-year jump-start has
paid off with almost three million dollars more in her pocket.
Summary & Comments
For most people, "Mary's" strategy -- put your savings into RRSPs,
then apply your tax refund to your mortgage -- is the ideal answer to the
"mortgage or RRSP" question. A well-diversified RRSP portfolio
could provide earnings considerably higher than the advantages of pre-paying
your mortgage and this assumption is the reason why there is such a huge
difference between two ending RRSP values in this illustration. The assumed
investment return of 12% is substantially higher than the mortgage rate
of 8%. This may not actually be the case in a real life situation and tweaking
the figures so that the investment return averages 6% rather than 12% leaves
Mary with an RRSP value closer to $664,000 and Bill with an RRSP value of
around $490,000 at age 65. Mary's ending RRSP value is almost $3 million
less in this case than with the 12% investment rate, which if nothing else
shows the power of compounding when investment yields are high.
There are shades of grey in any scenario and it
is best to work through your situation with prevailing rates and realistic
investment returns. The final picture for Bill and Mary would also look
different if they both accelerated their mortgage repayment by making
one extra mortgage payment per year. This would take several years of
payments off their mortgages and start the RRSP savings faster.
Use the Bill and Mary comparison as a jump start to review your own situation,
play with some figures using Fiscal Agents' calculators and see what you
can actually accomplish by aggressive debt repayment and dedicated savings.
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