Week 10 - Mortgage Payments or RRSP Contributions?

Many of us don't earn enough money in a single year to both maximize our RRSP contributions and maximize the amount that we can pay down our mortgage without penalty. So, each year we are faced with the choice of which vehicle to tackle.

In my mind, there are two ways of looking at this question.

1) Rates. If we think about each vehicle as an investment, by paying down our mortgage, we are saving the interest that we would have had to pay on that amount of money. So if your mortgage rate is 4%, then you are effectively getting a 4% return on your investment, since if you didn't pay it down, that's how much you'd have to pay each year. The question therefore becomes whether or not you can get a better rate of return by contributing to your RRSP. I might go a step further and suggest that the expected return from your RRSP better be pretty close to 'risk-free', since your mortgage rate isn't likely to go down from today's levels. What I mean by risk-free is that you can choose to buy stocks with your contribution but if your stocks go down, then you were better off paying down your mortgage. If you bought a bond that pays 5.5%, then you are better off doing that, since your mortgage rate is 1.5% less than that. So by this criteria alone, as long as we can get a higher low-risk rate of return in our RRSP, we are better off doing that.

2) Tax Deduction. Because mortgage payments are made with after-tax dollars, we know we are going to be immediately ahead by making an RRSP contribution, since we get the tax refund. By this logic alone, we might want to consider an RRSP contribution instead of a mortgage lump-sum payment. I will offer this argument, however. Remember that RRSP contribution room doesn't go away; we can always use it later in life. If we are only earning $50,000 per year now, we aren't even really getting that high a percentage of our tax back, compared to earning $100,000 down the road. So, it might make more sense to pay down the mortgage today while you are in a lower tax bracket and save your RRSP contributions for later in life when you are making the big bucks. If you don't see your salary increasing much from today's levels, you should probably contribute now, while you can.

Unless...

3) Sleep-at-night factor. Sometimes in life, we do things that may not make the most financial sense but they allow us to sleep better at night. For many people, this means paying down debt as quickly as possible. I could show you all the arguments in the world where RRSP contributions would make more sense than lump-sum mortgage payments but if you are someone who hates having debt, it's going to go in one ear and out the other. And you know what? There is absolutely nothing wrong with that. Regardless of our financial situation, the most important thing is being able to sleep comfortably with as little stress on our mind as possible. And with money being the number one reason people get divorced, we can see why the sleep-at-night factor might be the most important factor of all. Not to mention, mortgage rates rise. We never know how what rate we'll be able to get when we go to refinance down the road. Being able to refinance at a higher rate is less of a big deal, if we aren't needing as much money.

It was a relatively short post this week but this is one of the more common questions I get from people in this situation. I think I outlined the three most important variables, in my opinion.

What would I do? Well, it just so happens that I am completely debt-free and my RRSP is totally maxed out, so luckily, I don't have to make that decision ever again.

PFFFFFFFFFFFFFFFFFFFFFFFFFF!!!!!!

Seriously now? I try and do a bit of both. I like the idea of getting some tax back each spring and also reducing the amount of money we owe on our mortgage. Sometimes, the best strategy is to pay down your mortgage with your tax refund, killing two birds with one stone.

My last piece of advice on this is to speak to an accountant. They have no bias either way and will be able to offer their educated opinion for you as it applies to your own situation. Then you will have a better understanding when it comes time to make the decision.

Thanks for reading my blog.