Q: We have a small mortgage, only $80,000. Coming up for renewal at 2.35% for a five-year fixed rate. We have some money (approximately $25,000) that we can either put on the mortgage or invest or put into our RRSP. What is the best way to go?
A: Most of us have debt and most working adult Canadians will have RRSP and TFSA room. Some of us have group plans with matching contributions at work as well, just to complicate things. Making sure your cash flow is properly funneled is an important part of financial planning.
In your case, Linda, I note that you refer to your mortgage as a “small” mortgage. Small can be relative or based on your own perspective. If that feels like a small debt to you, that suggests to me that you’re not that “worried” about it. If someone has a modest mortgage relative to their home value, I would agree that’s less of a reason to focus on debt repayment versus investing. If you had 10% home equity, on the other hand, I’d be that much more inclined to build a bit of a buffer by paying down debt over investing.
I’m not sure if you mean your existing five-year mortgage is currently at 2.35% or that’s what you’ve been offered on your mortgage renewal. Either way, you should be able to get close on a fixed rate depending on your lender.
A quick way to think about debt repayment versus investing is to compare your interest rate to your expected rate of return. Say you have a $100 debt with a 2.35% interest rate. You’ll incur $2.35 of interest over the coming year. If you had the opportunity to invest that $100, you’d only need to earn $2.35 or a 2.35% return to have increased your net worth and be better off, right?
Unfortunately, the math is a bit more difficult than this rudimentary example, Linda. If you earn $2.35 of income in a non-registered account, it’s taxable. If what you earn is in a TFSA, it’s tax-free. If you earn it in an RRSP, it’s tax-deferred and you have to factor in the tax refund on the contribution and the eventual tax on the withdrawal.
Unless your RRSP or TFSA are maxed out, which I gather they are not, you shouldn’t be investing in a non-registered account (unless you have a group plan at work with a company match—always take that free money). I think in your case, your main options are RRSP or TFSA.
With an RRSP contribution of $25,000, you’re going to have a big tax deduction. You should consider whether that tax deduction would be more beneficial for you or your spouse, depending on your respective incomes and tax rates. I’d tend to focus personal RRSP contributions in the name of the higher income spouse.
A large deduction like that might be best to claim over two years, Linda. In other words, if a $25,000 deduction this year brought you down into a lower tax bracket, it might be advantageous to claim the deduction over two years. In Ontario, for example, if your taxable income is in the $80,000 – $90,000 range, your marginal tax bracket for an RRSP tax deduction could range from 31-43%. If you could take the full deduction in a 43% tax bracket in 2016 and 2017, rather than some of it at 31% in 2016, you could earn a 12% after-tax return by delaying the deduction. You would still make the contribution, but you don’t have to claim an RRSP deduction in the year it’s made. You can carry it forward.
With RRSPs, it’s not just as simple as comparing your expected return to your mortgage rate, but suffice to say that over the long run, you can generally earn a lower rate of return than your mortgage rate in an RRSP and still come out ahead. If your tax bracket is high, your risk tolerance for investing is high, your income in retirement is projected to be low or your timeline until return is long, these are factors that would help further reinforce an RRSP contribution over debt repayment.
TFSAs are a bit of a wildcard, because you can invest in a TFSA and then access the money for any variety of reasons—like paying down debt or making an RRSP contribution. A TFSA contribution could allow you to have the best of all worlds, keeping the savings accessible and then choosing debt repayment or RRSP contribution in the future, hopefully with a larger amount of money.
Without knowing all the facts in your situation, Linda, I might be inclined to lean towards an RRSP contribution due solely to the fact that your mortgage is modest and a MoneySense reader with a bit of money savvy can probably come out ahead in the long-run.
Both options are good ones, it’s just a matter of which is “more” good and more good is always a personal decision.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.