One of my goals as a mortgage planner is to help you integrate your mortgage into your overall financial plan. And with RRSP season moving into full swing, now is a good time to think about some of your long-term plans and how best to put yourself in a position to have a great retirement.
There is no one size fits all answer when it comes to a financial plan, and as with most things, we have a choice of going the DIY route or finding a financial planner that can help you with your plan. I am not a financial planner, but I would like to pass on to you some of the information I have come across in my personal search while building my own financial plan.
One of the biggest monthly expense most of us have is our housing costs. And if you own a home, the biggest part of your housing costs are your mortgage payments. If you can eliminate or reduce your housing costs by the time you retire, it will make life just a little bit easier. Because of this, I feel it is important to work towards having your mortgage paid off by the time you retire. If you do get to retirement, still have a mortgage and need to reduce your housing costs, you can always consider extending the amortization on your mortgage to lower your payments. How well this works will depend on how much is still owed on the mortgage when you retire. If you think you may need to extend the amortization on your mortgage, it is best to do this while you are still working and you have the income to qualify for the mortgage.
Before we look at the question of saving or paying off your mortgage, it might be helpful to see if the TFSA (Tax-free savings account) or RRSP is the better option for saving for retirement. Both the TFSA and the RRSP allow you to make similar investments. The income accumulates in the plans without having to pay annual taxes on that income. By not having to pay tax on an annual basis, your savings can grow at a faster rate. The biggest difference between the TFSA and RRSP is how the contributions and withdraws from the plans are treated. With a TFSA, you do not get a deduction when you make a contribution. However, neither the contribution nor the income earned on the contributions has to be included in your income when you take money out of the plan. With an RRSP you can claim your contributions on your tax return, which provides a tax savings when you make the contribution. Both the monies you contribute to the RRSP and the income earned on these contributions have to be included in your income in the year that you take money out of the RRSP.
So which is better, TFSA or RRSP? Again the answer will be different for each person, but it does seem that most financial advisors feel that if your annual income is $40,000 or less, it is better to use a TFSA for your retirement savings. The logic is that at this income level, the tax savings from contributing to the RRSP are lost when you draw the money out of the RRSP and have to pay taxes on the money at that time. In addition, because you are including the RRSP withdraw in your income, it could result in some of your government benefits being clawed back.
That leaves the RRSP as the preferred option of most financial advisors for people with an annual income more than $40,000. However, if you are one of the lucky ones that has a company pension with a defined benefit, you may want to consider the TFSA instead for the same reason as why the TFSA is better than an RRSP for those earning less than $40,000. You will have to include in income any monies you draw out of the RRSP and add it to the monies you receive from your company pension. It could put you in a higher tax bracket than when you made the contributions to your RRSP and result in you paying more tax overall.
Now, should you save in a TFSA or RRSP or pay off your mortgage? Here again the answer to this question can be different for each person, but I believe maybe the biggest consideration is knowing how comfortable you are with risk. This is important because we can calculate the rate of return you receive from paying off your mortgage. And this rate is guaranteed. If you compare this to the rate of return you can get from the investments you’re most comfortable with, it will help answer the question if it’s better for you to save or get your mortgage paid off.
To calculate the rate of return you get by paying down your mortgage sooner, you have to keep in mind that the interest on your mortgage is paid in after tax dollars. So to pay $1 in interest on your mortgage, you need to earn the $1 plus whatever you have to give to the government in taxes. For example, if the interest rate on your mortgage is 2.69 per cent and your tax rate is 30 per cent, you take the interest rate of 2.69 per cent divided by 70 per cent, which works out to a rate of return of 3.41 per cent.
Now that you know what your rate of return is for paying down your mortgage you can compare it to the rate of return on the types of investments you are most comfortable.
If you are conservative and more comfortable with GIC’s or term deposits, you may only be getting a 1.5 per cent return on your investments. If paying off your mortgage is providing a 3.41 per cent return, paying off your mortgage is the better choice. However, if you are comfortable with a bit more risk in your investments and can earn a higher rate of return in your TFSA or RRSP, saving may be the better option for you.
This is a starting point and hopefully gives you some things to think about. If you want to do a more detailed analysis, there are several free on-line calculators that you can use.
And as always, if you or anyone you know has a mortgage question contact me today at 604-961-2400!