RRSP or mortgage?

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It’s RRSP season and that means you can’t turn on the TV without some talking head trying to bully you into making a fat contribution. But if you’re younger and still paying off your first house, you shouldn’t be saving a cent for retirement this year. That’s right — it would be more prudent to forget contributing to your RRSP altogether and pay down your mortgage instead.

The debate as to whether you should focus on your RRSP or your mortgage has raged on too long. Part of the problem is that the banks win twice if your RRSP takes precedence: they get fees from selling you mutual funds in your RRSP, and they keep you in your mortgage for longer. That’s why their traditional advice is to put as much money in your RRSP as possible and then use your tax refund to pay down your mortgage. This approach certainly won’t land you in the poorhouse, but it’s not the optimum way to go.

Both shelter you from tax

The biggest misunderstanding in this debate surrounds the tax implications of the two approaches, says Malcolm Hamilton, actuary extraordinaire at Mercer Human Resource Consulting in Toronto. Many people think that your RRSP payments are tax sheltered and your mortgage payments are not. No wonder: when you put money in your RRSP the tax man sends you a juicy tax refund, but when you make an extra mortgage payment, you get nada.

But Hamilton says that RRSP payments have no significant tax advantage over mortgage payments. That’s because every time you make an extra mortgage payment you reduce the principal amount that you’ve borrowed, which means that you will pay less interest in total over the life of your mortgage. All of those future interest payments that you no longer have to make would have been made with after-tax dollars, so in effect, you not only save the interest, but the tax on that interest too.

It’s hard to get your head around, but the net effect is that you get a tax-free return on the money you use to pay down your mortgage, just like the tax-free return you get inside an RRSP.

It comes down to risk

If neither approach has a tax advantage over the other, then the next logical thing to look at is the return. Do you get a better return on your money by paying down your mortgage, or by investing it in your RRSP?

Most comparisons will tell you that you get a better return from your RRSP, but those comparisons don’t play fair. Usually they’ll compare, say, a 6% mortgage rate to something like an 8% return on your RRSP. Paying down a 6% mortgage is like getting a 6% return on an investment, so they conclude that the 8% return you get on an RRSP is the better deal.

That seems reasonable, but it’s not a fair comparison at all. That’s because the 6% return you get on your mortgage is a sure thing, and the 8% return on your RRSP is not. The truth is, a guaranteed tax-free 6% return is almost unheard of right now. An investment product offering such a return would devastate the market for GICs, T-bills and bonds as investors stampeded to the higher guaranteed rate.

Not only that, but the comparisons usually forget that the average mutual fund in Canada charges over 2% in fees, so the actual return you could expect from an RRSP after fees is more like 6%. “And in order to get that 6%, you’re going to have to take on the full risk of being in the stock market,” says Hamilton. “I think that most investors will appreciate that if you’ve got a choice between a high-risk 6% return and a no-risk 6% return, you’re well-advised to take the latter.”

The dangers of success

Since paying down your mortgage offers you the best risk-adjusted return, anyone who’s buying their first house should concentrate on that task, even if it means neglecting your RRSP contributions for a while. However, there are some dangers.

The biggest pitfall is that you’ll be so successful at paying down your mortgage that you’ll think you can afford a bigger house than you really can. You also have to keep in mind that once your first house is paid off, you really do have to get going on those RRSP contributions. If instead you decide to turn around and buy a bigger house, you could run into trouble.

The most important thing to remember is that paying down your mortgage and building your RRSP are both worthy causes. In the end, if your biggest financial concern is which one you should put your money in, you’re probably going to be just fine either way.