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Money Management

Pay down mortgage or contribute to a Registered Retirement Savings Plan (RRSP)?

October 11, 2006

I’ve been asked this question at least monthly over the past year. The rule of thumb I answer with is, it is best to contribute to an RRSP and apply the tax refund to your mortgage. Does this one size fit all approach work? Lets take a closer look.

Please keep in mind that your situation may be different and the factors to consider may make your decision complex.

The numbers. Lets assume your mortgage rate is 6%. One would assume that your "return" from paying down your mortgage is 6%. Most mortgages are not tax deductible thus you must earn more than a dollar to pay down a dollar in debt. In fact you will probably have to earn $1.50 to pay down $1.00 in mortgage debt. This boosts your after tax return on paying down your mortgage to over 10%. The higher the interest rate on your mortgage, the more attractive it is to pay down your mortgage.

Gain a tax break with RRSP. Even if you are at the lowest tax rate, an RRSP contribution will save you 26% in combined federal and provincial income tax. At the highest tax rate you might save 39%. When you compare the two, a $1 applied against your mortgage returns 10%, while the RRSP saves you at least 26% in tax.

Let’s try our rule of thumb i.e. contribute to your RRSP and apply the refund to your mortgage. Let’s assume I have $5,000 available and I am in a 32% marginal tax rate. By contributing to my RRSP, I should save $1,600 in taxes and get a tax refund. Once I receive the refund, I would then take the $1,600 and pay down my mortgage. I have created $6,600 out of $5,000, $5,000 went to my RRSP and instead of paying the government $1,600, I put it towards my mortgage.

Other considerations include taxation and financial goals. There are different tax implications of owning RRSPs and owning a home. When you retire and start withdrawing funds from your RRSP, the funds taken from your RRSP (usually converted to a Registered Retirement Income Fund or RRIF) will be taxed. This is somewhat offset by the tax-free compounding you receive within your RRSP and the possibility that you will be in a lower tax bracket when retired. Contrary to gains in an RRSP, gains made when a principal residence is sold are not subject to tax.

Weighing the goals of providing for your future and your attitude concerning debt are additional considerations. Some of our members make debt repayment their #1 priority and have difficulty with the concept of owing money, even owing the Christian Credit Union. They reason that once their mortgage is paid off, they are no longer indebted to anyone and can then use that money to provide for their retirement and have more flexibility with regards to job changes or other life choices without having to worry about mortgage payments. There are others who are more concerned about providing income for retirement and focus on contributing to RRSPs and other savings. They reason that with advances in health care and a healthy lifestyle, they may be "retired" 30 years. They like the benefits of compound growth and the immediate tax savings that RRSP contributions provides.

The key point is that everyone’s situation is different. Both paying down your mortgage and contributing to your RRSP are excellent financial goals. If you would like an individual assessment on contributing to your RRSP or paying down your mortgage, please call me at (780) 426-7165 or out of town, toll free 1-877-426-0506.

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