Question. Hi, I recently received an inheritance of $50,000. Currently, I have about $107,000 in my RRSP, and since I’ve never been able to maximize my contributions, I have a contribution limit of over $60,000. Also, I owe $220,000 on my mortgage. My question is, what should I do with the $50,000 inheritance? Should I contribute it to my RRSP, or should I use it to pay down my mortgage? How can I decide which one is better for me?
Answer. This is one of the most debated questions in all of personal finance – Should you contribute to your RRSP to increase your savings, or pay down your mortgage to reduce your debt?
While it can indeed be difficult to figure out the best course of action, deciding what to do with your new $50,000 is a nice “problem” to have. Of course, this is only a decision to the extent that you have the RRSP contribution room available – if you have insufficient or no contribution room, the RRSP contribution isn’t even an option, so it would be a simple choice. But since you’ve indicated you do have the RRSP contribution room available, let’s take a look at some key considerations to keep in mind during your decision process.
Do you want a tax deduction?
Contributing to an RRSP results in a deduction from income. Making a lump sum payment on your mortgage does not. This may be particularly attractive for those with higher incomes, and correspondingly higher marginal income tax rates.
Recall that, if you have a higher taxable income, RRSP contributions are generally more beneficial as they result in a higher refund. So if you want to lower your taxable income, and potentially end up in a lower marginal tax rate, the RRSP is the way to go.
Is your mortgage open or closed?
Generally speaking, with an open mortgage, you can make a lump sum payment of any amount, and at any time, without a fee or penalty. However, closed mortgages typically have payment limits. Terms vary from one institution to the next, with most closed mortgages allowing you to make a payment of 10% to 20% of the original principal balance of the mortgage, per calendar year. So if you have a closed mortgage, you may just have to wait for a specific date.
Be sure to check the specific terms and conditions for your mortgage, and determine what you can and cannot do, or what the penalty would be if you decide to make a lump sum payment. This alone can be a determining factor.
What is your mortgage interest rate?
These days, mortgage interest rates are quite low by historical standards. As such, given today’s low rates, if you think that investing in your RRSP will give you a higher rate of return, then the RRSP is the way to go.
However, it’s not always just the math. Some of us are more debt averse than others, while others are comfortable carrying debt. In that sense, paying down your mortgage can also offer peace of mind, as it provides guaranteed savings. This is in contrast to the potential investment earnings in your RRSP, where returns are typically not guaranteed.
What will be your RRSP rate of return?
In order to make a meaningful comparison, we need to consider the rate of return in your RRSP, in comparison with your mortgage interest rate. That is, if your mortgage interest rate is higher than the rate of return you think you will earn in your RRSP, it may be better to make the mortgage a higher priority. On the other hand, if you think you will earn a higher rate of return in your RRSP, then it may be more advantageous to direct your money toward the RRSP.
Of course, while your mortgage interest rate is generally pre-determined, the rate of return earned in your RRSP is typically not known in advance. Unless you’re investing in assets such as GICs, which have explicitly stated rates of return, you’ll have to make an assumption about the rate of return you expect to earn in your RRSP.
RRSP Contribution AND mortgage payment: Best of both worlds?
Here’s a potential strategy to consider – why not contribute to both? There are a couple of ways you could do so.
One way would just be to split the $50,000 and pay a portion down on the mortgage, and contribute the other portion to your RRSP. For example, you could do $25,000 toward each, or any other combination that makes sense in your situation.
Another way to achieve both is to consider the tax refund that typically accompanies a large RRSP contribution. The refund can then be used to pay down the mortgage. As an example, assume you’re in a 40% marginal tax rate, and you contribute $50,000 to your RRSP. This results in a $20,000 tax refund, which you can then use to pay down your mortgage. See what happened there? You only had $50,000 to begin with, but now have ended up with a $70,000 total contribution – $50,000 into the RRSP, and $20,000 down on the mortgage.
However, keep in mind that, depending on your income, it may not make sense to contribute a large sum to your RRSP in a single year. For example, if your income is $50,000, it would not make sense to claim a $50,000 RRSP contribution in that year, even if you have the RRSP contribution room available to do so.
Properly directing and allocating your cash flow is a critically important part of financial planning. Should you contribute to your RRSP or pay down your mortgage? As we’ve seen, there really is no universal one-size-fits-all answer. More importantly, the answer can be “both” – it doesn’t always have to be one or the other.
Furthermore, every individual situation is unique, so there are often other considerations that are relevant in any given scenario. For example, if you have children, paying off the mortgage before your kids go to university may be an important consideration, as it may provide you with additional capacity to help your children cover their education costs.
Before making your decision, make sure to ask yourself the questions we have outlined above, and to consider any other additional factors that are relevant in your situation. That should help you make a more informed decision, and help you decide which course of action makes the most sense for you.
If you want to speak with a professional advisor, or if you have any other questions about RRSPs, or any of our services at ModernAdvisor, just contact us.