Buy now, save later

We tell young people they should save for retirement and pay off their mortgages at the same time. But in this era of lofty home prices, that’s often impossible. Here’s a different plan that can help you to do both.

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by

From the June 2012 issue of the magazine.

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The great financial quandary for many Canadians in their 20s and 30s is how to save for retirement and also buy their first home. The classic advice—made famous by David Chilton in The Wealthy Barber—is you should put away at least 10% of your pre-tax income for retirement, even when you’re trying to save for a down payment or pay your mortgage. But can you do both at the same time with today’s lofty housing prices?

In most cases, you no longer can. Since the first edition of Chilton’s book appeared in 1989, the wages of typical Canadian workers (barbers or otherwise) have not kept up with the rising cost of houses, especially in larger cities. In my view, the slow and steady 10% savings rule just isn’t realistic for most young homeowners these days. So what should you do instead?

Consider an alternative strategy devised by Malcolm Hamilton, partner at Mercer, a human resources consultancy. You might call it the 20% strategy. He suggests earmarking 20% of your income for either housing payments or retirement savings throughout your life: “The entire 20% goes to the mortgage until the mortgage is gone, then the whole 20% goes to the RRSP,” says Hamilton.

I agree this strategy should help a lot of young Canadians afford a home and save for retirement. But Hamilton and Chilton agree it’s not for everyone. Will it work for you?

Different ways to build wealth. The beauty of the 20% strategy is that it allows you to successfully achieve two of life’s biggest financial goals. Early in life you can focus on buying as nice a house as you can afford, and you’ll pay off the mortgage as quickly as possible as your salary grows. Next you save for retirement in an intense, concentrated period. In my experience, this approach fits well with how most people naturally set their priorities.

Saving for retirement just isn’t important to most Canadians in their 20s and 30s, who are often desperately eager to buy a comfortable home in a good neighbourhood. But after buying that home, they chafe under the mortgage and want to get it off their backs as soon as possible. Then finally they turn their focus to building their retirement nest egg at a stage of life when that becomes increasingly important. It can all work out perfectly well, since paying off your mortgage and building up your investment balance are just different ways to build wealth.

To show how the 20% strategy could work in practice, I have developed a fictional scenario for a typical middle-class Canadian couple we’ll call Eric and Jennifer. Starting in their mid-20s, Eric and Jennifer set aside 20% of their income in order to accumulate a down payment on a home. Then in their early 30s they’re able to buy a $325,000 house with a mortgage of $260,000 (in today’s dollars). Each year they increase their mortgage payments in proportion to their growing salaries in order to pay it off in 17 years, just before they turn 50.

With the mortgage gone, they turn to building up their nest egg by applying 20% of their income (plus RRSP tax rebates) to savings. That allows them to save $525,000 (again, in today’s dollars) by the end of the year they turn 65. That’s more than adequate to provide a comfortable retirement.

Customize the strategy. Adopting this mortgage and savings plan at the 20% level should suit Canadians in average circumstances, says Hamilton. But to sustain their lifestyle in retirement, affluent Canadians should save more, while low-income Canadians will need less, he says.

Other circumstances may force you to tweak the strategy. Many young people are hobbled with enormous student debt and can’t start saving for a down payment immediately after graduating, although a good education might help earn bigger salaries later on. The plan also assumes you will have virtually no savings until you’re in your late 40s or early 50s, which isn’t the case for many people. Few Canadians outside the public sector enjoy good defined benefit pensions anymore, but many will by then have significant amounts in more modest employer-sponsored plans, or RRSPs and TFSAs. For better or worse, you’ll probably need to adjust the numbers accordingly.

Do you have the discipline? While Hamilton’s strategy should ease the path to home ownership and retirement savings for many Canadians, that doesn’t mean it’s easy. Like the slow and steady 10% savings approach, it too requires discipline. To do it properly, you first need to increase your mortgage payments as your salary increases in order to pay off the mortgage quickly. As a rule of thumb, if you have no other substantial savings or pension, you need to pay off your mortgage 15 to 20 years ahead of your retirement date, says Hamilton.

Then when you’re mortgage-free, you need to have the discipline to change gears: after decades of putting it off, you will need to suddenly embrace investing. That means socking away the full 20%, and avoiding the temptation to buy a larger house with a new mortgage, or ramp up your lifestyle expenses. (In my view, most people should also save their RRSP tax rebates on top of the 20% to make the most of the strategy.)

This is harder than it may sound. Chilton talks to a lot of people about their finances, and he says that while many Canadians are good at paying off their mortgages, he finds a large proportion don’t subsequently save enough when the mortgage is gone. After all, unless you’re willing to let the bank foreclose, you don’t have any choice when it comes to your mortgage payments. But you can come up with a dozen reasons not to invest regularly.

“I have no issue with people doing Malcolm’s approach as long as they avoid the behavioural issues,” says Chilton. Hamilton himself agrees that if you think you may lack the discipline to save large amounts late in your career, you’re probably better off sticking with the traditional approach.

Slow and steady wins some races. Indeed, while the 20% mortgage and savings rule should work well in many cases, it’s not for everybody. If you can start early and save a steady 10% of your income without jeopardizing your dreams of home ownership, then do it. The 10% rule recommended by Chilton is a proven strategy. Consider the fictional example of Hannah, a single woman who earns $50,000 a year (in today’s dollars) throughout her career. By saving 10% plus RRSP tax rebates over 40 years, she’d accumulate $450,000 nest egg in today’s dollars (assuming a conservative 5% return with inflation of 2.5%). That should provide her with a comfortable retirement if she also owns her home mortgage-free.

But the slow and steady strategy has potential pitfalls of its own. In particular, you’ll need to save more if you start late. “If you start at 46—or even 35—you have to save more than 10%,” says Chilton. “This is something we haven’t driven home as well as we should.”

Consider the example of Sergei, who has the same income as Hannah, but only starts saving at around age 40, leaving him just 25 years before retirement. Sergei has to save about 20% of his income to accumulate about the same nest egg as Hannah did by saving 10% for a longer period. In addition, if you’re a renter, you should probably save more than 10% to compensate for the fact that a paid-for home is a valuable asset that reduces your accommodation costs in retirement compared to equivalent rental properties.

Plan for the unexpected. No matter how good your plan, you never know how things will work out. With luck, the pleasant surprises (bigger salary increases, better investment returns, an unexpected inheritance) will at least offset the bad (maybe rising mortgage rates or falling housing prices after you purchase, or personal misfortune such as divorce, business failure or job loss). As Hamilton says, all you can do is “steer up the middle” and adjust when necessary.

That’s easy if the good surprises exceed the bad. But what if events turn out unfavourably? One thing to realize is that saving 20% of your income after your mortgage is paid off often leaves room to save more if you need to catch up. My sense is that saving 20% represents a moderate level of frugality for Canadians who are mortgage-free (see “How much can you save?”) If need be, you can probably save about 25% of your income, or more if you set your mind to it, especially late in your working life if you have no children, or if your kids are financially self-sufficient. And that’s not counting RRSP tax rebates. If you save those as well, that could bring your overall savings rate to 30% or more. So even if things don’t work out as you hoped, there’s a lot you can do to catch up.

While Chilton and Hamilton recommend different saving strategies, they hold each other in great regard. They also wholeheartedly agree that the best general advice you can follow is live within your means, pay down your mortgage and other debt as quickly as you can, and steadily build up your savings for retirement as soon as you can manage it. Do that diligently and you should enjoy a comfortable retirement—whatever strategy you use.

4 comments on “Buy now, save later

  1. I think the 20% has another advantage it keeps you from comparing your mutual fund or etf or whatever with what you are paying on your mortgage. It takes a pretty disciplined person to hold onto a mutual fund that sheds 10% or 20% in one year while they are holding a mortgage that they are paying 5% on, come hell or high water. But it is precisely at the point when their equity portfolio is at its lowest that most people would be tempted to cash out and apply that against a mortgage, thus losing out on great potential gains. I think working on one goal at time keeps you from comparing the different vehicles you use to build your wealth.

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  2. Just as house prices went higher as interest rates went lower over the past 30 years, the opposite also holds true. The housing market has always been cyclical. Good luck making payments on that $500,000 house when interest rates start to go up. If you think you can't save for retirement now, you certainly won't be able to do it then.

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  3. I think another possible option for some 20-30 year olds is the ability to save for retirement while paying off the mortgage. If any savings has been done previously, they can take their RRSP and pay off an existing mortgage. Holding the mortgage now in the RRSP equates to a lower interest rate and monthly payment, meaning more savings potential and greater earnings.

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  4. Good article with many great points. I am a bit skeptical of the plan to save starting just before 50 and only having $525K put back by retirement. These days, $1M is seen as tough to live on for 15+ years. I'd be surprised if that would come close to cutting it 30 years from now. I, instead, would sway young people to consider the options of coupling their mortgage with RRSP savings in order to leverage cash and make further investments, the interest on which can be put toward savings.

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