The annual financial debate: RRSP or pay down the mortgage?

Whether you choose to contribute to an RRSP or to pay down the mortgage depends on your situation.

It’s that time of year and soon the articles on the RRSP versus mortgage debate will start. Obviously the RRSP-sellers want you to choose the first option because the more money they have under their administration, the more fees they will make.

But is the RRSP the better option? Well, it depends on your situation.

First, note that the question is never “Should I contribute to an RRSP or pay down my credit-card debt charging 20% a year?” That’s because the answer in this case is a no-brainer. Anyone with a revolving credit card balance at that high rate of interest should not be making an RRSP contribution. No investment portfolio today is going to consistently beat a 20% per annum rate of return after taxes and fees, which would be achieved by getting rid of the credit-card debt.

So let’s assume you have no ugly high-interest debt and the only debt you have is a mortgage.

The commonly accepted answer is to make the RRSP contribution and use the tax refund to pay down the mortgage. Let’s use an example to illustrate. Say you have $10,000 in cash available, and you are in a 40% marginal tax bracket now and will be when you cash in your RRSP. We’ll also assume the mortgage can be paid down by the amount available.

Let’s assume a 4% rate of return after fees on your RRSP and a 4% effective annual rate on the mortgage (prime is currently 3% so this is prime plus 1%).

To make this an apples-to-apples comparison, let’s focus on a 10-year period where you are trying to determine the best use of your money.

Option one is to pay down the mortgage with the full $10,000. If you did this, you would have nothing in your RRSP and a mortgage that was $10,000 lower for the 10-year period.

Option two is to make a $10,000 RRSP contribution and with the income tax refund of $4,000 you pay down the mortgage to $6,000.

In 10 years your $10,000 RRSP grows at 4% compounded annually to $14,802. You then withdraw the money and pay tax at the 40% marginal tax rate. That leaves you with $8,881 cash in hand.

But during this 10-year period your mortgage grew at 4% per year. After 10 years the $6,000 mortgage balance that you did not pay down grew to $8,881, which is the original amount of $6,000 plus $2,881 of cumulative interest. So with this option you would have $8,881 from cashing in your RRSP and you could then pay off the mortgage of the same amount. That puts you back at the same position as option one — zero RRSP and zero debt.

This analysis assumes your marginal tax rate remains constant. If your marginal tax rate is lower when you make the RRSP withdrawal, the RRSP wins. If your marginal rate is higher upon withdrawal, paying the mortgage down wins. In our example, say your marginal tax rate is 46% now and only 36% when you withdraw your RRSP, the RRSP option wins by $1,480. If the situation is reversed and your marginal rate is 36% now and 46% upon withdrawal, paying the mortgage down wins by the exact same amount.

You must also consider future investment and mortgage rates. According to Fiscal Agents, a deposit broker, the average five-year closed mortgage rate available as of early November 2013 was 4.14%. Assuming your marginal tax rate is going to remain level, are you quite sure you will make at least that on your RRSP? If so, stick with your RRSP; otherwise go with the sure thing and get rid of that debt ASAP.

I have created a spreadsheet to enter the variables in each situation and then project the optimal solution. You can download it free from my website.

In this column I plan to address a variety of financial matters that I hope will be of benefit to you. Please send me your thoughts about financial issues that are important to you. Perhaps you have a nagging question you would like investigated. I am always looking to benefit from the knowledge of others, so don’t hold back.