TAX AND ESTATE PLANNER, TD WEALTH
Investing your spare cash versus paying down your mortgage is a classic financial conundrum for which there is no “magic solution.” Each situation is different, yet the starting point is the same: You are using after-tax money to invest or pay down the mortgage.
Here are a couple of quick assumptions. While employed, many of us will be paying off a home while continuing to save regularly for retirement.
So, let’s assume you’ve been conscientiously doing both. Next, without knowing your personal situation, I can only make general comments.
The case for paying down your mortgage
If you can make an extra monthly payment to the principal every year, it (very roughly) knocks eight years off a 25-year mortgage. With interest rates historically low, paying it down makes a large impact.
If you’ve seen the value of your home rise 100% in the past 20 years, you may wish to fully enjoy the future gains of a paid-off home (if they continue) as soon as you can.
Taking a longer view, the sale of your principal home is an important consideration once it’s paid off. Accessing a $1 million gain on the sale of your home versus accessing $1 million out of your Registered Retirement Savings Account (RRSP) will result in a different financial outcome. The gain on your home is tax-free (because of the Principal Residence Exemption you receive) while the funds from your RRSP will be taxable at your marginal tax rate (in Ontario, the highest marginal tax rate is 53.53%).
So far, it appears paying off your mortgage is a judicious decision.
However, one cannot ignore some basic financial planning guidelines, namely that of avoiding being house rich and cash-flow poor. Beware of paying down the mortgage while underfunding retirement savings.
It’s ironic how people know the month they will have their home paid off yet are unaware what kind of money they’ll need for retirement. You may be on track, you may be wildly off the rails but unless you sit down with an advisor or planner, you may not know how much you should be saving.
The argument that your house is your retirement plan carries its own risks. Primarily, you have not diversified your retirement investment (i.e. your home) and its value may fluctuate and fall short of the desired return needed. Further, once you do sell, you still have to live somewhere which will draw down your proceeds of sale. With soaring house prices, it’s possible your next residence will be more expensive than you reckoned on.
The case for investing any spare money
As mentioned, you should max out your after-tax or tax deferred contributions first, by way of investing in your RRSP and/or your Tax Free Savings Account (TFSA).
An RRSP is one of the better means to help meet the financial needs of retirement. The past decade has been fruitful for investors. According to TD Economics, Canadian investors on the whole have experienced solid 5% to 7% annual portfolio gains, outperforming those of the previous decade.1 Who knows, your returns to date may have exceeded your goals and you can afford to move toward paying down the mortgage. Again, you should get a professional to make these calculations.
When you contributed to your RRSP, you received a tax deduction which reduces your taxes in the year you made the contribution. Applying the tax refund to your mortgage may be another option worth considering.
Compared to an RRSP, a TFSA has a relatively low annual contribution limit but its versatility has some advantages. If you can maximize your TFSA annual contribution, your investment grows tax-free and is accessible at any time (contrary to the value of your home). You may also consider this strategy to help pay down your mortgage: You try to max out your TFSA every year leaving some funds in liquid assets. If you’re happy that you have invested enough at year’s end, transferring some funds toward the principle of your mortgage can be helpful.
The flexibility of the TFSA helps because, if you feel you should invest more one year, the funds are already in an investment account — you can always pivot back to your mortgage when you’re able. Also, if an emergency arises, funds in your TFSA are readily available.
There are few disadvantages to investing additional funds in any given year unless you are making inappropriate investments. Your investment plans should always align with your financial plan.
Get some good advice
The decision to pay down your mortgage or make increased investment contributions is not mutually exclusive. The key point to remember is to start with after-tax money and apply it where the return will remain tax-free, or tax-deferred.
Truth be told, as long as your finances are in order and you established a plan that suits your situation, there’s probably no wrong answer as long as you are making an informed decision. Don’t forget, your advisors can look at your finances and give more personalized advice on your unique situation.
Sébastien Desmarais is a Tax and Estate Planner who assists business owners and high net worth families at TD Wealth with their tax, estate and business succession plans. Sébastien also helps clients with cross-border estate and tax-planning issues.
- “James Orlando, “Canadian Long-Run Financial Market Returns” TD Economics, July 29, 2019, accessed Mar. 25, 2021. https://economics.td.com/canadian-long-run-financial-market-returns ↩