Michael A. Healey,
B.A., CFP, CLU, CHS, Associate, ZLC Financial Group
Stance: do what lets you sleep at night
I tell clients to avoid debt wherever possible, especially non-deductible debt such as mortgage interest.
Whether or not it’s critical to retire debt-free depends on each client’s personal circumstances and comfort with debt.
While most people in retirement derive income from a combination of pension plans, RRIFs, and government benefits, that combination usually doesn’t add up to pre-retirement incomes. So carrying a substantial mortgage into retirement puts a burden on other lifestyle and retirement goals.
Mortgage or RRSP?
So what do you say to a client who asks whether to put funds in an RRSP or pay down her mortgage?
If it’s an either/or choice, it makes more sense to fund the RRSP, especially for younger clients with longer accumulation periods. Compound interest is a powerful tool—the longer money builds up on a tax-deferred basis within the RRSP, the bigger the ultimate retirement nest egg.
Take a 45-year-old who has $500 per month of excess cash flow and is weighing the option of putting it toward his mortgage versus making additional RRSP contributions. Assume the RRSP hasn’t been maximized in prior years and there’s more than enough contribution room to absorb the additional $6,000 per year.
Let’s also assume:
- Outstanding Mortgage Principal: $500,000
- Mortgage Interest Rate: 4%
- Amortization Period: 25 Years
- Monthly Mortgage Payment: $2,640
- Planned Retirement Age: 70
- Return on RRSP Assets: 6%
- Marginal Tax Rate: 40%
By increasing the monthly mortgage payment by $500, this client reduces overall mortgage costs by more than $165,000, and the amortization period from 25 to 19 years.
Yet, increasing monthly RRSP contributions by the same amount results in additional accumulation of $203,000 over the same period, in addition to about $45,000 in tax savings.
In addition to making more frequent mortgage payments (bi-monthly or weekly if possible), some institutions offer hybrid mortgage banking products that shorten amortization and significantly reduce the amount of interest paid.
A hybrid account works like a mortgage line of credit—the outstanding principal is calculated daily based on the inflows and outflows to the account.
So whenever a paycheque or other deposit is made, the amount owing is immediately reduced, and when withdrawals are made, the amount owing goes back up. Let’s say your outstanding mortgage principal is $500,000. If you deposit a paycheque for $10,000 on the 15th, the principal for that day will go down by $10,000; the interest would fall accordingly. Such hybrid arrangements can take years off a mortgage and save several thousand dollars in interest payments over the lifetime of the mortgage.
Depending on whether one receives rental income from a cottage or vacation property, it may make more sense to carry a mortgage longer as the interest may be deductible against the rental income. But carrying high debt loads into retirement can also result in tighter cash flows. I’m fine with clients leveraging for real estate investment as long as they can comfortably service the debt and are able to absorb potential increases in interest rates. Ultimately, the property should be cash flow positive, or at the very least, cash flow neutral.