August 27, 2007, 7:00 am

RRSP Contribution VS Lump Sum Payment on Mortgage II: Answering a reader’s question

by: The Financial Blogger    Category: Personal Finance
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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, I’ll revisit my calculation to show what would happen in such situation.

Let’s say you have a mortgage of 200K over 20 years at 6% (let’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. Don’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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Comments

Interesting post, I never thought about counting the interest saved as an investment contribution which I think is a good way to calculate.

One point – you mention that the interest amount adds up to $37,961.18 in the rrsp. Then you reduce this amount by 35% for taxes – this is incorrect since the marginal rate only applies to certain parts of the withdrawal. If you go to the income tax calculator on taxtips.ca you can find out the correct net income. When I plug in the $37,961.18 for Ontario I get a net income of $31,136 with an average tax rate of 18% (not 35%) as you have.

The same issue applies for the rrsp side of things, the $40,169.43 rrsp will result in a net income of $32,624.

This may not change the argument very much but it’s a more accurate way to calculate the effects of taxes.

Mike

by: The Financial Blogger | August 27th, 2007 (9:37 am)

Mike,
When I wrote about this topic, I used Ernst & Young marginal Tax Calculator. I used the marginal tax rate instead of the average tax rate.

It is true that if your RRSP withdrawal is your only source of income, your average tax rate on the withdrawal of 38K or so will be 17% (according to EY). However, if you receive Gov pension income along with a private pension income, your RRSP withdrawal have better chance to be taxed at a higher rate. However, as we used the same tax rate in both example, the effect will be the same.

As you noticed in my 2nd post on this topic, there are several ways to look at this situation. This is what is so great about Personal Finance ; one problem, several solutions 😉

Good point, I normally assume there is no pension since I won’t have one but obviously that won’t be the case for everyone.

Mike

Great analysis. The thing I find frustrating is at the end of the day it boils down to them being pretty much equal.

I’ve always played around with RRSP scenarios and tried to get the best deal. For example, when I graduated I was making 30k a year – I went through great debate to decide weather I should use my RRSP deduction in the year or carry it forward to another year where I will be at a higher tax rate. I ended up using the deduction and taking the dollars today.

Thanks for the plug too!

by: The Financial Blogger | August 28th, 2007 (7:29 am)

911, I Know, I was a bit disappointed to find out that both strategies are almost equal in term of money. I guess that when you factor in everything, several techniques will come down to this results 🙁

One thing to consider is that this is only effective if you are applying for a new mortgage or up for renewal. If you have an existing mortgage, paying down $10,000 will not affect your monthly payments, just shorten the length of the mortgage.

You may want to run the numbers for the senario where you invest in the RRSP, then apply the refund to the existing mortgage.

Or what happens if you take that $4000 return and either invest it or pay down your mortgage.