The Canadian Capitalist had a link to article by the Smoke & Mirrors guy, David Trahair, called “Don’t Invest in an RRSP Before Paying Down Your Mortgage (*Link no longer available*).” He starts off by saying that the conventional wisdom of investing in an RRSP then applying the tax rebate to your mortgage every year is hard to do. Instead, he says, don’t contribute to an RRSP, but put down more principal on your mortgage. If you want to talk psychology about what is “harder to do” I would suggest that contributing your maximum room to an RRSP is a better forced savings plan than applying an extra lump sum on the principal of your mortgage ever year, but that’s just me. Or maybe he’s suggesting you re-amortize for a much shorter period (after forgetting about RRSPs) but he doesn’t say that explicity. His second argument is that banks just want your money for RRSPs so they can charge you “commissions and fees on your contributions,” and because the banks’ ideal is for you to be in constant debt. I don’t buy any of that as a reason to pay down a mortgage instead of an RRSP. What I care about is *which one is better for me (regardless of whether the bank benefits)*. Just like I don’t care about MERs in principle. What I care about is the returns after costs.

In the latter part of the article, he argues why you should pay down your mortgage before contributing to an RRSP by showing an example of a couple in two scenarios. Scenario 1 has them paying their monthly mortgage payment and contributing to an RRSP $4000 each per year and investing the tax refund generated. Scenario 2 has them paying their monthly mortgage payment and instead paying $4000 each year onto the principal value of the home. 11 years into Scenario 2 the home is paid off so they redirect what was their mortgage payment into their RRSP (and they invest the tax refund generated into their RRSP). I’ll give you the punchline:

The debt pay-down scenario shows a net worth slightly higher than for the RRSP scenario—a difference of $14,590. So, after 20 years, the Harts would arrive at a similar point but would have taken a very different journey. The debt pay-down option, however, has two major advantages: it reduces the risk that the Harts could lose their house during the nine years of mortgage-free living, and there is less risk related to investment returns. How much confidence do you have that the markets are going to post better returns than the interest rate on your debt? Are you willing to stake your future on it?

This sounds very reasonable but I am very disappointed in his article for a few reasons. He assumes a rate of return in the RRSP of 5%. This seems unbelievably low to me. There might be a reason for that. Since paying down the mortgage (he assumes a fixed-rate of 6%) is low-risk he’s probably trying to match the risk in the RRSP and the mortgage. I am not sure why you couldn’t at least get 6% in the RRSP for almost the same risk. Secondly I would assume that the majority of people with large mortgages or any mortgage are younger rather than older. We can take on a little risk right? I mean we could at least put half our RRSP in equities and half in fixed income/bonds. A 5% return in an RRSP seems *unrealistically* low. And this is coming from someone (me) who sets his expectations fairly low (7-8%). Thirdly, he doesn’t explain what would happen if the rate of return were even a bit higher yet the difference in Scenario 1 over Scenario 2 is tiny compared to the other numbers involved. “The debt pay-down scenario shows a net worth slightly higher than for the RRSP scenario—a difference of $14,590.” Clearly his cooked up his numbers so that they work out to be better for the mortgage pay-down scenario. Because it’s not even a difference worth mentioning. He even says in the next line that the end points are similar: “So, after 20 years the Harts would arrive at a **similar point** but would have taken a very different journey.”

I tried to replicate his calculations in a spreadsheet of my own so I could try out some other combinations of rates. (You can now skip to the next paragraph if you get bored easily). I was pretty much successful, only off by a small percent. This is due to the complicated way that he decided to handle the tax rebates. When Joe and Karen each contribute $4000 per year to their RRSP they get a tax rebate equal to $4000 multiplied by their marginal tax rate (40% in this case). They take that $1600 tax rebate and contribute $4000+$1600 to their RRSP in the following year. Then they get a $2,240 tax rebate and contribute $4000+$2240, then the following year, $2,496 extra, eventually converging to some value. I already talked about this “snowball effect” before. Note that it is non-existent if you maximize your RRSP contributions every year anyways. (Do not NOT maximize your RRSPs just so you can get this effect. It’s not that exciting.) Anyways, another way to handle this in the simulation would have been to just assume the max contribution room every year was $4000 for each of them or whatever, and contribute the excess cash available into a non-RRSP account. Personally I would do the latter since we maximize our contribution room every year. Any excess monthly cash (that might come available after paying down a mortgage) would go into non-RRSP investments.

Anyways, if you just increase the RRSP rate of return a little bit, as you can see in this modified spreadsheet, the RRSP case beats the pay-down-debt case. If you increase the rate it beats it by a wider margin but never by much.

I think the takeaways here are:

- That paying off a mortgage is a great low-risk investment.
- Make sure you look carefully at any assumptions used in calculations by accountants and financial advisors. Are they realistic?
- When looking at a return, never forget about the risk associated with that return.

I found that article yesterday while researching the post and I had a few comments on it as well:

– 5% returns for an aggressive portfolio is way too low. I’d guess it is more like 8%.

– 6% interest rate on a mortgage is a bit too high. These days, it is more like 5%.

– He assumes that RRSPs are melted down in one year and a 40% tax paid on it. This is unrealistic because most people will withdraw a little bit every year.

So, the answer to the debate depends on the assumptions made. I am a bit agnostic on the debate and think either option is fine: a 5% after-tax return by paying down the mortgage is not a bad strategy.

CC you beat me to my own comments! As much as I liked Smoke & Mirrors – I agree his analysis is a bit one-sided (biased?) Drawing down the rsp all at once? That’s just stupid. Personally I use 7% as a long term rsp return estimate. 5% is pretty conservative although if you have a conservative portfolio then it might make sense.

Dave – great post – it’s hard to find objective analysis on the web or in books and that’s what you did. As both of you noted, it all boils down to the assumptions. I’m hoping to pay off my mortgage in about 10 years from now – I have no idea if my 7% estimate for investment return will be accurate over that time period which isn’t really that long. Another assumption that interest rates will stay at 5% is just a guess as well. Interest rates have been known to go up the odd time 🙂

He doesn’t actually draw on the RRSP all at once. He said:

“Scenario 1 shows a higher RRSP value, but to access those funds the Harts would have to pay taxes on any withdrawal. To pay off their mortgage, they would have to cash in $198,336 of their RRSPs, pay $79,334 in tax at 40 percent,

and be left with the required $119,002. That would leave them with only $58,438 in RRSPs versus $91,974 for the debt pay-down scenario. The higher amount of net worth is deceptive because a large portion of it is pre-tax.”

I’m assuming this is the paragraph that you are both referring to? No where does that one-time RRSP withdrawal enter into his calculations. He is simply demonstrating that after 11 years, to really calculate their total assets correctly you have to take the RRSP as being pre-tax (and multiply it by (1-T)) and the house and liabilities as being post-tax. In other words he’s using an example of pulling all the money out of the RRSP at once to demonstrate the fact that in Scenario 1 they don’t quite have so much compared to Scenario 2 as it looks because the RRSP in both scenarios will be taxed eventually upon withdrawal.

For anyone else, I’d like like to clarify that his total assets calculation is probably not the ideal way of doing it. His “total assets” line includes the addition of pre-tax assets (the RRSP) and post-tax assets (the house) and liabilities (the mortgage). It is probably better to convert all to post-tax, then add them up. In other words the entire RRSP should have been multiplied by (1-T), where T is some assumed marginal tax rate before being added to the other assets.

I was just referring to CCs comment. I don’t recall the details from the book.

Oh, well I think CC and I are referring to the PDF, not the book.

Dave: My mistake. I should have read the article more carefully. Still, the first two points apply to the article.

As I said over the at the Canadian Capitalist, there is another assumption in these calculations:

The calculations assumed the same marginal tax rate when contributing to the RRSP and the same when withdrawing from the RRSP later. For some this may be true, for others, maybe not. Again, it’s an assumption and one that can affect the results you get out in the end.

I have something to add to the equation that I am trying to calculate in my own life. My wife and I don’t have 20% equity in our home yet, so we are paying $63 for PMI every month. Normally I am an advocate for putting more money in a retirement account rather than paying down a low-interest rate mortgage, but in this case, it may be advantageous for us to pay down the mortgage until our PMI is removed. What do you guys think?

$63/month is a significant cost so maybe that should tilt the argument towards paying the mortgage down sooner? Are you close to getting to the 20% equity?

No, we’re not very close to 20% equity yet. We didn’t put much money down, and we just bought the place one year ago.

Chris, well I am lazy so I’ll make an approximation. I’ll assume the $63/month needs to be paid for the entire duration that you have the mortgage. ie. from now until your equity is 100%. This will slant things a little bit but it will allow us to see how much things will change.

So in scenario 1 (RRSPs) instead of putting $8000 total into their RRSPs then can only put in $8000-($63*12). They pay that for their entire 20 years. In scenario 2 (debt paid) instead of putting down $8000 total into their RRSPs then can only put in $8000-($63*12) for the first 11 years, until their house is paid off. Then for the next 9 years they can put in $8000 into their RRSP.

This is a pretty gross approximation, but let’s see if it worked.

Originally, the two plans worked out about the same if the rate of return on the RRSP was about 5.7%. When I added in the $63*12/year mortgage penalty the rate of return of the RRSP had to be upped to 6.6% in order to match the debt pay-down option. If you case, you stop paying the PMI sooner so this will have less impact than it did in my approximation.

Of course if your RRSP is smaller to start with than the couple in the example, than the lower RRSP contributions will make more of an impact. If you have a $1 million nest egg already, then the reduction in your RRSP contributions will be negligible.

Let me know if you want the spreadsheet.