Amid mounting household debt, millions of Canadians are forced to make the difficult choice between saving for retirement and paying down the largest and longest lasting debt, their mortgage.
According to the latest figures from Statistics Canada, the total credit-market debt (mortgages, consumer credit and non-mortgage loans) among Canadian households has jumped to 162.6% of disposable income, the bulk of which is resulting from continued borrowing for home purchases.
Against that backdrop, having to choose between saving for retirement and paying down the mortgage may seem like fighting a losing battle to the vast majority of Canadians able to afford only one or the other.
How to decide? Cynthia Kett, a principal with the advice-only firm Stewart & Kett Financial Advisors Inc. in Toronto, suggests considering your mortgage rate on a pre-tax basis.
"If you're in a 50% marginal tax bracket, your pre-tax mortgage rate would be double your stated rate," she says. "A 2.5% mortgage rate would be equivalent to 5% on a pre-tax basis. By paying down your mortgage, you're earning a guaranteed rate of return equal to the pre-tax mortgage rate. Where else could you get the same risk-free rate of return?"
And the faster you pay off your mortgage, the less total mortgage interest you'll have to pay. "You reduce the amount of your mortgage that may need to be renewed at a higher rate than you now pay," adds Kett.
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| Cynthia Kett | |
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David Trahair, a chartered accountant and author of Crushing Debt, says that in addition to marginal tax rate on RRSP contribution versus at withdrawal, the math behind the decision comes down to rates of return. "If you think your RRSP is going to beat the rate on your mortgage, stick with your RRSP. If not, go with paying off debt."
In the right circumstances, says Trahair, an RRSP offers a great tax advantage. Investing in an RRSP makes sense "if the person is in a high marginal tax bracket when they make the contribution, and therefore get a significant refund, and a low marginal tax bracket when they withdraw from their RRSP in retirement."
For people in a low marginal tax bracket, though, making an RRSP contribution offers much less bang for their buck. "If they also withdraw from it when their tax bracket is higher, it makes it even worse," Trahair adds.
Unless you can afford to do both, paying off the mortgage trumps the RRSP because of the psychological benefit of being mortgage-free sooner. "Being debt-free is the ultimate freedom and significantly reduces the financial stress of retiring," says Trahair. "A declining income after retirement does not fit well with the requirement to continue large monthly mortgage or home equity line of credit (HELOC) payments."
Risk-takers who feel confident they can make an excellent return on their RRSP could be stuck, due primarily to poor returns, with a small RRSP and still hold a mortgage going into retirement, cautions Trahair.
Further, a shrinking tax benefit is making investing in RRSPs less advantageous, at least for Ontario residents. The 2014 Ontario budget included provisions to raise marginal tax rates for individuals earning between $150,000 and $220,000 to 47.97%, from 46.41%, and 49.53% from 46.41% for individuals making more than $220,000.
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| David Trahair | |
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Another consideration is that RRSPs are discretionary. "You don't have to make contributions and you can take out the money at any time, even though you'll have to pay when you do," says Trahair. Second, people just don't have the money after paying all the other bills.
According to Statistics Canada, the total unused RRSP contribution amount is estimated to exceed $1 trillion by 2018. This suggests that Canadians are likely to stay committed to reducing mortgage debt rather than building retirement savings within RRSPs.
However, deciding whether to pay down your mortgage or build up your RRSP ultimately comes down to personal circumstances.
It depends on the size of mortgage and the interest being paid, the age of the person and what stage they're at in the life cycle, says Jonathan Chevreau, a veteran financial writer who runs financialindependencehub.com.
"For young people, paying down debt is a certain winner," says Chevreau, author of Findependence Day, a book about achieving the financial flexibility needed to retire. "RRSPs in equities can go down and the tax refund is less compelling if they are not in the top tax bracket."
In the years when interest rates were at double-digit levels, the argument in favour of RRSP contributions would have been more compelling, he adds.
As for people near retirement, especially if in the top tax bracket, they may want to maximize the RRSP, says Chevreau, but maintains they should strive to be debt-free once in retirement.
"Paying down a mortgage is a guaranteed return while RRSP is not. Plus, the RRSP is only a tax deferral," says Chevreau. "You can be blinded by the refund only to regret the future tax liability once it becomes a registered retirement income fund (RRIF) with forced annual and taxable withdrawals."
That said, some households are able to invest in RRSPs while also paying down their mortgage. Chevreau, along with his wife, maximized their RRSP contributions and still managed to pay off their mortgage in five years. "Those with risky careers, however, may prefer the certainty of a paid-for home and focus on RRSPs in the second half of life," he says.
