August 23, 2007, 7:00 am

RRSP Contribution VS Lump Sum Payment on Mortgage

by: The Financial Blogger    Category: Personal Finance
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I recently ran into this dilemma when reading Four-Pillars’s post about his next x-mas bonus. FP, was wondering what to do with his next year end bonus: invest the money into his RRSP account or make a lump sum payment on his mortgage. These seem to be two valid options with different implication. I decided to push my thoughts a little bit further to know which option would be the best thing. Please note that I might have a biased opinion on the subject as I already believe that you should not focus on paying your mortgage.

By paying your mortgage faster, you are concentrating your effort on paying off your bigger debt. Therefore, looking at your mortgage statement that shows a drop of 10K in the balance owing might be very appealing. I understand also that many people sleep well at night knowing that they are mortgage free. However, keep in mind that by doing so, you are focusing on paying your cheapest debt in term of interest rate. You can probably lock your mortgage for 5 years for 6% right now.

This means that if you put a lump sum payment of 10K, you will be saving 6% on that amount for the time of your mortgage. Let’s say that you will pay off your mortgage in 20 years. You will then save interest on 10K over 20 years. This equals to $12,000 in interest fees (10K*6%*20years).

However, if you invest the same 10K into your RRSP and earn 7.2% out of it for a 20 years period, you will get $40,169. Why is that? The power of interest compounding! You will make a profit of $30,169 before taxes compare to 12K saved in interest. Please note all amounts do not include inflation. But then again, the difference will still be there.

In order to get your RRSP to 22K (which would be equivalent to 10K plus the 12K of interest you are saving from your lump sum payment), you would require a small 4.02% yield. Even a lame GIC can make it.

Well… how about taxes at the time of withdrawal? Ok. Let’s say that your marginal tax rate will be 35% at retirement. Therefore, you would need $33,846 if you withdraw the whole amount in 20 years. This would require an annual yield of 6.29%. Even then, this is a pretty conservative rate over such amortization.

What would happen if the market goes down and you are not making such yield? You know what? The money you put against your mortgage will always remain. In regards to investment, it is only speculation. The real dilemma is more based on the following basis: Do you think your investment can make more than 6.3% annually over 20 years? I guess it is really a matter to know if your mortgage really bothers you to that level or not. I am personally optimistic over my investment’s perspectives and I do believe I can average more than 6.3%!

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Comments

What if the person investing the interest savings each year and put it in their RRSP?

by: The Financial Blogger | August 23rd, 2007 (9:15 am)

911,
I think you just point out a good point. I’ll make the calculation and come back with another post on this topic.
Great idea!
FB.

I would also take the Kiyosaki view of this whole puzzle. i.e.: having investable income.

I think what you’ve missed in the math here is the assumption about how you calculate mortgage interest, I could be wrong, but don’t mortgages normally take their interest first and isn’t this interest pre-calculated? Check out this link to see what I mean. On a 25-year mortgage more than half of your payment every month is going to pay off interest for the first 15 years! Your number of 12k interest fees is way too high, b/c that not how it’s calculated.

If you’re in say year 2 of a 25-year mortgage and you pay down your 10k bonus here’s what you’ve done.

1. You’ve added 10k to the ownership of the house, i.e.: what you could use for a HELOC (which carries its own interest)

2. You’ve knocked off the last 10k you were going to pay on the home. (sometime in 2030)

If you have a 200k mortgage that last 10k is nearly irrelevant. You’ve shaved like 6-12 months off the mortgage using today’s dollars and you may have shaved minor dollars on the monthly payment (depending on your term). But you were going to pay that amount using 2030 dollars which are worth much less anyways.

The extra value of the HELOC is pointless b/c the banks charge you for the HELOC so you might as well have the money in an account and not pay them interest (unless you’re implementing the SM). Your house is both an investment and an expense. Try not to throw too much money at an expense.

As to where to put the money, there are several questions worth asking:

1. Do you have an “expense fund” for your home and your car. I know that you just finished paying down the car, but what are you with that extra money? The car and the home have recurring expenses on the scale of months and years, but if you put 10k on the Mortgage and then have to use Credit to repair a leaky roof next summer, then you haven’t made any headway.

2. Are you maxing out your RRSP contributions? Do you even need to? RRSP money is income supplementation, but it’s rotten deal when you can’t buy your Jag at 55 b/c everything’s in RRSP and the house.

3. Is there something else that could use all or part of that bonus? Do you have short-term investment opportunities available? Can you convert that 5k into something useful?

If you don’t have a home/car expense fund, I would put aside at least part of that bonus in the ING/PC Financial/etc. bank account so that you have cash on hand to pay for upkeep of your stuff.

If you still have money left over, think about a 50/50 RRSP/Investment split. You’re already investing into your RRSP regularly and you’ve already done the math about how much money you need (right?). Throwing more money at the RRSP saves you taxes, but it also generates income you don’t need, b/c you’ve already met your RRSP goals. I say half b/c it will make you feel better to have some extra there (I know I would feel better 🙂

But take that other part and try to do some investment today, see if that great brain of yours can convert the money into something bigger. Maybe you could take a course or do some professional development, or just pay for a babysitter for the weekend so that you can catch up on some financial reading. If you can take a $500 accounting night course (+ $500 for the babysitter), I’m pretty sure that you could parlay that knowledge into way more than $1000 over the next few decades!

by: The Financial Blogger | August 23rd, 2007 (4:58 pm)

Gates, that is a comment and a half :mrgreen:
In fact, you are right about my interest calculation. I am presently writing another post on further calculation suggested by Investing911 and I point out my mistake.
However, this dilemma does not really apply to my personal situation. My pension plan is pretty big and I will be left out with a small room for RRSP contribution (about 3K I would say, I’ll know next year as I just started my contribution to my pension plan a year an a half ago).
I put all my extra money on my Smith Manoeuvre payment. I put $600 a month in capital (whatever the interests are). If I would to use a regular mortgage, I would pay off my mortgage in 18 years (considering a raise in the interest rate of another 0,5%).
I think the SM is a good way of distributing money between my property (it still increase in value over time), my non-registered investment (SM) and my rrsp/pension plan.

David Ingram would state that the payment of the mortgage has higher value. How much would you have to earn to pay the $600 annual interest cost of the $10,000? If you are in the 40% tax bracket , you’d need to earn about $1000 per year to pay the interest cost if you placed the $10,000 in an RSP instead of placing it on your mortgage.

You also do not describe what happens to the tax return from the RSP. The fate of that amount can also tip the balance at withdrawal. There is much information on thed net indicating that investments outside an RSP have a better return, unless the tax return is also invested into the RSP.

DAvid

by: The Financial Blogger | August 24th, 2007 (7:09 pm)

David, I noticed that I only hit the tip of the iceberg with this post (this is what happen when you type with a 2 weeks old baby in your arms while the other 2yr old is running around… thinking of having children now ? LOL!).

Like I said, I will write more about the subject shortly.

by: Prashanta | May 22nd, 2009 (11:59 am)

You will then save interest on 10K over 20 years. This equals to $12,000 in interest fees (10K*6%*20years).
=> This is an incorrect statement.

Hi!
I love these scenarios and thought I would solicit some opinions!

I have two properties, mortgage owing as follows:

A) $36K, I pay $600 weekly at 3.79% my house)
B) $230K, I pay $250 weekly at 3.54% (rented to my folks)

If I have 20K availaible to make a priveledge payment, which mortgage should I pay down? I am leaning towards prop B because the principle is so much higher.. but I can claim the interest on this property. I have an annual income of 90K plus 12000 rental income.

Thoughts ?

by: The Financial Blogger | January 20th, 2010 (10:15 pm)

@Jane,

I think you would be better off paying the first one for 4 reasons:

#1 as you mention, your rental property has tax deductible interest.

#2 you are presently owing 266k total. once you have paid 20k in debts, you will owe 246K. It doesn’t matter if you owe it on house A or house B, the debt is still the same.

#3 The interest rate on your house is higher.

#4 You will be closer to pay off your house in full (especially at $600 weekly). Once paid off, you will be able to snowball your payment to your rental property mortgage and pay it down faster.

I hope it helps!

TFB.

OK, I had my wife crunch the numbers to justify the loan example you give.

First, it’s important to note that 28% is a guideline, not a rule. And more importantly, you’ll notice in the mortgage information link you provide, 38% is the guideline used for total debt, so if this person had no other debt, now the lender can justify up to a 38% DTI (Debt to Income ratio). And in the heyday of all this, she’s says they would do loans up to 45% DTI, not to exceed 50%.

Now your example. Get your mortgage calculator out. A $385,000 loan, over 30 years on a teaser rate of 1.25% (a very common rate back then) with no money down would give you a monthly payment of $1,283. 1283/2900*100= 44.24% DTI! My wife says her company would’ve given out this loan in a heartbeat.

Scary, and of course ultimately doomed.

Completely smacks of banks giving ridiculous loan amounts to internet start-up companies 7-8 years ago. You’d think they’d have learned their lesson the first time…