Pay Down Your Mortgage or Make an RRSP Contribution? There’s a Third Option

If you’ve received a bonus, an inheritance, or another financial windfall you may face an enviable financial decision: contribute to your Registered Retirement Savings Plan (RRSP), or make a prepayment to your mortgage.

The answer depends on your situation. Use these questions to help make the wisest choice. Yet you also have a third option: do both.

How Much of a Tax Refund Will an RRSP Contribution Generate?

Contributing to an RRSP will generate a tax refund based on your income tax rate. This depends on both your income and the province or territory that you live in. Once you estimate your RRSP tax refund and potential growth you’ll have a better idea you can compare it against the interest savings generated by a mortgage prepayment.

The higher your tax rate, the bigger your tax refund. And since investment growth within an RRSP is tax-free, you’ll delay paying taxes on it until you withdraw it – hopefully in retirement when you’ll be in a lower tax bracket.

Some people may feel more concerned about inadequate retirement savings than they are about paying down their mortgage. If you’re worried that you’re not saving enough for retirement, use a retirement planning calculator to get a quick look at your current retirement savings situation.

If your employer offers to match your RRSP contributions, applying a windfall to your RRSP instead of your mortgage could be an even better choice, because you’ll get a tax refund as well as double the RRSP contribution.

How Much Home Equity Do I Have?

Your home equity is your home’s current value less your outstanding mortgage balance. When you make mortgage payments, your mortgage balance decreases and your equity increases.

Many people hope to pay off their mortgage prior to retirement to avoid the monthly payment once they’re on a fixed income. The lower your balance and the more equity you have, the more flexibility you’ll enjoy when approaching retirement.

If you don’t have much equity and it’s important to you to retire mortgage-free, you may want to use your lump sum for a mortgage prepayment.

How Much Mortgage Interest Will I Save in The Long Run If I Make a Prepayment?

As long as a mortgage prepayment gets applied directly to the principal, you’ll save the interest that would have been charged on that amount. Yet the exact savings depends on your current mortgage rate, and the remaining amortization -- how many years left before your mortgage is paid off. Use a mortgage calculator to determine how much interest you’ll save from making a lump sum prepayment.

For example, say you have 15 years left on your mortgage, a current balance of $100,000 and a rate of 4.49%. You’ll pay $37, 225.94 in interest over the next 15 years. Yet if you make a $10,000 prepayment, you’ll pay just $28,659.26 in interest, and save $8,566.68 in interest over the next 15 years.

Tip: Most mortgages allow some form of prepayment penalty-free. Yet if you’ve already made a prepayment or doubled-up your payments during the current year of your mortgage term, you could face a charge to make an additional lump sum payment.

Still Can’t Decide? Do Both

The financial benefit of contributing to an RRSP instead of paying down your mortgage depends on many factors – your income tax rate, the number of years until you retire, the rate of return within your RRSP, your mortgage rate, and the remaining years left on your mortgage.

Instead of choosing one over the other, it’s possible to do both. Simply make the RRSP contribution with the lump sum payment, then apply your tax refund as a mortgage prepayment. This way you’ll boost your retirement savings as well as reduced your mortgage interest costs.

To learn more about RRSP contributions and mortgage prepayments, visit your local Kawartha Credit Union branch today and speak to one of our knowledgeable financial advisors.