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. Letâ€™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.
Wellâ€¦ how about taxes at the time of withdrawal? Ok. Letâ€™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 investmentâ€™s perspectives and I do believe I can average more than 6.3%!
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