I have an extra $1,200.00…what should I do?
This might be one of the most asked personal finance question in Canada. Most people would lean towards putting money into an RRSP because of the tax credit and the possibility of a higher return. However, some people don’t realize the tax savings related to reducing their mortgage principle.
So what is the right answer? To help you make the right decision we must first look at both options.
First let’s look at the pros and cons of each strategy:
· Putting extra money against your mortgage will certainly help you become mortgage free and debt free sooner.
· Your mortgage payment is a combination of interest and capital, but in the early years of your mortgage more of your payment goes to interest.
· Any “pay-down contribution” goes entirely against the capital and cuts the length of time and total interest paid dramatically.
As an example, if we have a $120,000 mortgage with a 25 year amortization period, paid monthly, adding that extra $1,200.00 per year for five years would reduce the repayment schedule by 1yr 8 months and could save $8,033.04 in interest.
Sounds good doesn’t it? And most people would elect to put this into action, but we still need to look at the effects of putting those funds into the RRSP.
If you take this amount and invest it into your RRSP, not only will that money grow tax deferred each year, but you also receive a tax credit for the annual contribution. This can result in a tax refund that we have all received at some point in our working years. The key is to make sure we use the refund to reinvest verses using it as a cash windfall for a holiday or simply spending it.
Let’s look at the numbers:
If we invest that same $1,200.00 in each of the next five years, with an annual rate of return of 5% you would have $6,962.00 in your RSP. Now let’s assume you take your annual refund and invest it back into your RSP. Assuming a marginal tax rate of 22.70%, your RSP could now be worth $8,605.00 in year five.
Saving for your retirement is always a good idea and taking advantage of compounding growth and tax deferral will see you build a sizable nest egg for your retirement.
Looking back at our example, with an interest rate of 3.89% on the mortgage, and if you can realize a rate of return of 5% each year in your RRSP, then on paper investing the extra funds seems like the right choice. However there are no guarantees that the markets will produce a 5% rate of return year after year.
The rates we pay and the returns we earn are not guaranteed. So what is the right choice? Like most things, there is no right answer and it will depend on your personal situation. However both options or a hybrid approach should be evaluated to determine the impact on your financial plan.
Kevin J. Zakus, is the Managing Partner at Zakus Kowalchuk LLP in Kelowna, British Columbia. You can email him at [email protected].
Kevin’s opinions and comments expressed are his own and may not accurately reflect those of the firm. The information contained in this post is not intended as investment, tax or legal advice and is provided as information only.