Contribute to RRSP or pay off mortgage?

In your case, Linda, I note that you refer to your mortgage as a “small” mortgage. Small can be relative or based on your own perspective. If that feels like a small debt to you, that suggests to me that you’re not that “worried” about it. If someone has a modest mortgage relative to their home value, I agree that’s less of a reason to focus on debt repayment versus investing. If you had 10% home equity, on the other hand, I’d be more inclined to build a bit of a buffer by paying down debt over investing.

Comparing mortgage interest to investment returns

A quick way to think about debt repayment versus investing is to compare your mortgage rate to your expected rate of return. Say, you have a $100 debt with a 5% interest rate. You’ll incur $5 of interest over the coming year. If you had the opportunity to invest that $100, you’d only need to earn $5 or a 5% return to have increased your net worth and be better off, right?

Unfortunately, the math is a bit more difficult than this rudimentary example, Linda. If you earn $5 of income in a non-registered account, it’s taxable. If what you earn is in a TFSA, it’s tax-free. If you earn it in an RRSP, it’s tax-deferred and you have to factor in the tax refund on the contribution and the eventual tax on the withdrawal.

Unless your RRSP or TFSA are maxed out, which I gather they are not, you shouldn’t be investing in a non-registered account (unless you have a group plan at work with a company match—always take that free money). I think in your case, your main options are RRSP or TFSA. (Check your RRSP contribution room and TFSA limit.)

Considering the tax implications of investments

With an RRSP contribution of $25,000, you’re going to have a big tax deduction. You should consider whether that tax deduction would be more beneficial for you or your spouse, depending on your respective incomes and tax rates. I’d tend to focus RRSP contributions in the name of the higher income spouse.

A large deduction of $25,000 might be best to claim over two years, Linda, depending on your income. In other words, if a $25,000 deduction this year brought you down into a lower tax bracket, it might be advantageous to claim the deduction over two years. In Ontario, for example, if your taxable income is in the $86,000 to $106,000 range, your marginal tax bracket for an RRSP tax deduction could range from 30% to 43%. If you could take the full deduction in a 43% tax bracket, rather than some of it at 31%, you could earn a 12% after-tax return by delaying the deduction. You would still make the contribution, but you don’t have to claim an RRSP deduction in the year it’s made. You can carry it forward to deduct and reduce your income in a future year.

TFSA vs RRSP

With RRSPs, it’s not just as simple as comparing your expected return to your mortgage rate, but suffice to say that over the long run, you can generally earn a lower rate of return than your mortgage rate in an RRSP and still come out ahead. If your tax bracket is high, your risk tolerance for investing is high, your income in retirement is projected to be low or your timeline until return is long, these are factors that would help further reinforce an RRSP contribution over debt repayment.

TFSAs are a bit of a wildcard, because you can invest in a TFSA and then access the money for any variety of reasons—like paying down debt or making an RRSP contribution. A TFSA contribution could allow you to have the best of all worlds, keeping the savings accessible and then choosing debt repayment or RRSP contribution in the future, hopefully with a larger amount of money.

When an RRSP makes more sense than paying off a mortgage

Without knowing all the facts in your situation, Linda, I might be inclined to lean towards an RRSP contribution, due solely to the fact that your mortgage is modest. And a MoneySense reader with a bit of money savvy can probably come out ahead in the long run.

Both options are good ones, it’s just a matter of which is “more” good and more good is always a personal decision.

Read more about investing and mortgages:

• Should you accelerate your mortgage payments—or invest?
• Should you hold your mortgage inside your RRSP?
• Marriage or mortgage: Which is the better investment?
• Mortgage renewal calculator

About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.

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