After I wrote my post about the dilemma between making RRSP contribution vs making a lump sum payment on a mortgage, Investing911 asked what would happen if you are investing the interest you are saving into your RRSP after making the lump sum payment on your mortgage. Today, Iâ€™ll revisit my calculation to show what would happen in such situation.
Letâ€™s say you have a mortgage of 200K over 20 years at 6% (letâ€™s presume the interest rate will stay the same for calculation purposes). The monthly payment would be $1,424.28. Instead of keeping the mortgage at 200K, you make a lump sum payment of 10K. Therefore, you would only have 190K to pay over 20 years. Your monthly payment would drop at $1,353.16. You would then save $71,12 per month over 20 years.
If you invest this money into your RRSP at a rate of 7.2% (to keep the same investment yield than the previous post) over 20 years, you would get the amount of $37,961.18 in your pockets.
When I used the CanEquity mortgage calculator, I also find out that you would pay a total amount of interest of $141,849.77 over 20 years with a mortgage of 200K compared to $134,757.50. This makes a difference of $7,092.27. This amount is much less than what I previously posted (12K with calculation of 10K*6%*20years).
So while saving $7,092.27 in interest fees, you will also accumulate the amount of $37,961.18 into your RRSP. Donâ€™t forget that you would also get a tax return of $6,827.52 ($71.12*40%*12months*20years) if your marginal tax rate is 40%. Once you withdraw your RRSP investment at a 35% marginal tax rate (at retirement), you would get a net amount from your contribution of $24,674.77. The total benefit (net of taxes but not adjusted with an inflation rate) is $21,502.29 ($24,674.77 from RRSP + $6,827.52 from tax returns – $10,000 from the initial lump sum payment).
If you invest the 10K into your RRSP at 7.2% over 20 years, you would get the following result: $4,000 in tax return the first year and a RRSP account showing a balance of $40,169.43. Once you withdraw the RRSP, you will get $26,110.13 net of taxes. The total benefit is therefore $20,110.13 ($26,110.13 net from RRSP + $4,000 from tax return – $10,000 from the initial lump sump payment).
Please keep in mind that I did not take into consideration the interest advantages you save from the first scenario as you need the extra cash down to invest this money into an RRSP. Both scenarios have the same investment rate, borrowing rate and cash flow results.
I did further more calculation and if your investment yield goes over 8%, you would be better of with the 10K invested in the RRSP. At this point, it shows that both strategies give about the same results. So unless you think you can get 10% over 20 years or if having a lower balance on your mortgage account makes you sleep well at night, you are better off with making a lump sum payment on your mortgage and invest the difference. A big thank you to Investing911 and also Gates VP to bring up the question and to show an interesting alternative to this dilemma!
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