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RRSPs / Mortgages / Taxes

RRSPs / Mortgages / Taxes

Paying down my mortgage, or contribute to my RRSP which comes first ??

I’m often asked this question, which should come first, paying down your mortgage, or contributing to your RRSP.  My best strategy is to do a bit of both: If you can afford it, make an RRSP contribution to generate a bigger tax refund; then invest that refund in your mortgage every year.

 

Real Estate / Mortgages: When you buy a home, you take a huge step towards creating a tax-efficient wealth. Your principal residence will likely be the primary and largest single sponsor to your overall net worth; it’s an investment that can provide tax-exempt capital appreciation, the potential for rental income or a home based business, and the leverage with which to acquire new income-producing assets.

Buying real estate comes with some big risks as well. Home mortgages represent more than 77% of all Canadian debt. That debt can become a crushing burden if you suffer a job loss, marriage breakdown or you are forced to renew your mortgage at a much higher interest rate.

While capital gains enjoyed on the sale of your principal residence are not taxable, but losses incurred are not deductible either—so it’s doubly painful if you must sell in a hurry at a loss.

Needless to emphasize, you need to manage the purchase processes very carefully. The interest rate you pay is a very important factor, especially because mortgage interest costs aren’t tax-deductible, unless your home is used for a home business.

Manage your wealth: A basic wealth management principle is to manage the non-deductible debt on your home mortgage by cautiously paying it down, often. Negotiate the opportunity to make lump sum pre-payments annually. Also, consider making weekly or biweekly payments instead of monthly payments. By doing so, you end up making a few extra payments a year, which quickly reduces the amortization period and the total interest paid over the lifetime of the mortgage.

Paying down your mortgage, or contributing to your RRSP which comes first:

A very common question, I’m often asked: which should come first, paying down the mortgage, or contributing to RRSP.

Generally speaking, the best strategy is to do a bit of both: If you can afford it; make an RRSP contribution to generate a bigger tax refund; then invest that refund in your mortgage every year.

Example:
Let’s assume you are in a 35% marginal tax bracket, and can contribute $12,000 annually to your RRSP. This will reduce your taxes by $4,200 a year, and when you get that tax refund, you can use it to pay down your mortgage. This even works much better if you can apply your tax savings to your mortgage throughout the year.  You can do it by asking your employer to reduce the taxes withheld at source to account for your RRSP contribution, then increasing your mortgage payments by the difference—in this case, by $350 a month. If you had a $375,000 mortgage at an interest rate of 5%, those extra payments would cut your amortization period by almost six years and save you $75,000 in interest costs.

You would also have accumulated about $480,000 in your RRSP, assuming a 35% tax bracket and a 7% compounding return. If your tax bracket stays constant in retirement you would be left with close to $312,000 after taxes, which you could continue to grow in a Tax-Free Savings Account. Your net worth statement, in short, would be quite impressive: featuring just over $1.5 million in assets. The icing on the cake is that your home value appreciates on a tax-exempt basis. And once equity is built up, it’s possible to secure a loan against your home for investment purposes, making the interest deductible; but only for investments in non-registered accounts.

You have more complicated situations, what should you do first—contribute to your RRSP or the mortgage?

The answer is, it depends: on the mortgage rate you are paying, the rate of return on your invested financial capital, and your marginal tax rate.

We have created tools to help you estimate your potential net worth under different scenarios, using different interest rates, RRSP contribution levels, marginal tax rates and a variety of rates of return on your RRSP investments. With our tool you’ll quickly discover that no matter which path you choose, your home will be a major contributor to your wealth in the years to come.

To find out which option is the best fit for your particular situation, give us a call at 416.454.8812 or email at mina.hanna@accountingontrack.com

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