Should You Use Home Equity to Catch Up on an RRSP Shortfall?
February 19, 2015 | Posted by: Calum Ross
A common dilemma faced by homeowners is, should I contribute to my RRSP or pay down my mortgage? If you speak with your parents or grandparents who grew up during the Great Depression, they’ll clearly favour paying down your mortgage. While that strategy may have worked when they were growing up, it doesn’t necessarily make sense today.
Significant price increases have forced homeowners to take on more debt than ever before. It’s not unheard of to have a mortgage of $500K or more today (in fact in my office very common). Paying off a mortgage that big is no easy task. If you listened to your parents and concentrated on paying down your mortgage, it’s going to take a very long time to reach mortgage freedom. In fact, you could be in your 50’s or 60’s before you finally rid yourself of the shackles of your mortgage.
While paying off your mortgage and not carrying debt into retirement is a good thing, it comes at a cost. Unless you have a gold-plated defined benefit pension at work, be prepared for a rude awakening in retirement. By paying down your mortgage all those years, you’ve forgone another important financial goal: saving for retirement. Not only have you put all your eggs in one basket, you’ll have very little time to build up a sizable nest egg to live off of in your golden years. Low-interest rates may help borrowers, but they certainly don’t help savers. You’ll have to sock away even more money for retirement in less time. Worse yet, many homeowners who spend all those years reaching mortgage freedom decide to downsize or rent.
If you’ve built up substantial equity in your home, it usually comes at a cost. You’re probably used to seeing your Notice of Assessment each year with an unused RRSP contribution room number that keeps on growing. With RRSP season in full swing, you may be wondering if it’s wise to borrow to invest. The good news is with interest rates near all-time lows, there’s never been a better time to borrow to invest (as long as it’s done right).
Although the interest on borrowing to contribute to your RRSP isn’t tax-deductible, it’s still a strategy worth considering. If you’re a homeowner who’s diligently paid down your mortgage, you can tap into that equity at fixed or variable rates near or at a lifetime low (a bargain by historic standards).
Interest Rate vs. Rate of Return
It is key to know that borrowing to invest isn’t a strategy for everyone. If your plan is to put all your money in Guaranteed Investment Certificates (GICs), or Canada Savings Bonds then borrowing to invest simply is not the right strategy for you. The whole point of borrowing to invest is achieve a rate of return greater than the interest rate you’re paying on your mortgage.
When you borrow to invest, it’s not as hard to come out ahead as one you’d think. At a 40% tax rate interest cost is 40 percent less. To put this in perspective, a 2.5% variable rate mortgage becomes 1.5% percent after interest deduction. As an investor, as long as you’re able to earn an after-tax return greater than 1.5% you come out ahead. BIG TIP: you don’t need an MBA from a fancy business school to get an after-tax rate of return of 1.5% … to get that return you essentially need the money and a pulse.
Know Your Marginal Tax Rate
Borrowing to contribute to your RRSP makes the most sense when you’re in a higher tax bracket. The higher your tax bracket, the more you’ll benefit. For those at a 40 percent tax rate or higher, borrowing from your home equity to catch up on your RRSP contribution room is a no-brainer.
Don’t Over-Contribute ..or it will cost you!
It’s important not to contribute too much. The whole point of contributing to an RRSP is to defer tax until retirement when you’re hopefully in a lower tax bracket. If you contribute so much to your RRSP that you don’t have any pay any taxes, it defeats the purpose. Figure out what non-refundable tax credits you’re entitled to. Everyone is entitled to the basic personal amount. You may be entitled to other tax credits like the caregiver amount or spouse or common-law partner amount. Contribute above those amounts, otherwise, you won’t benefit.