Mathematics behind deciding to do a lump sum mortgage payment vs. RRSP contribution?

Question

If I have 10,000 extra dollars, how could I decide between doing either:

1. A lump sum mortgage prepayment (2.1% variable closed interest rate, 250k remaining balance), or,
2. An RRSP contribution (marginal tax rate is 30%)

What is the math behind the decision? What other information is needed to do the math?

Answer 1

To answer this question, you should ask these questions:

-How much do you expect your money will grow in your RRSP? (you can use any Compound Online Calculator for this, I use http://crosstowncivic.mb.ca/index.php?option=com_content&view=article&id=118&Itemid=118)

-How much will your lump sum payment save you in interest? (I looked at this one: http://crosstowncivic.mb.ca/index.php?option=com_content&view=article&id=118&Itemid=118 )

Then you can decide what's better in your situation. From a quick calculation using the websites above, the lump sum option will save you almost $3k in interest over 25 years, while investing these $10k will grow to $33k over the same time period (considering a return of 5%).

Since your mortgage interest rate is relatively low compared to a decent investment (5%), your best return is to invest.

Note, however, that we are talking only numbers here. If you think you will have a little peace of mind making the lump sum payment, go ahead and forget about the numbers. It's better to be able to sleep at night than be mathematically correct, sometimes.

Hope it helps!

Answer 2

There is quite a lot of math to worry about here:

• are you currently at your top marginal tax rate? If not, do you have an idea of how long it will be until you are there? You might not want to use up RRSP room if you will get a larger tax credit using that room next year.
• is this a once-in-a-lifetime lump sum, or the first of many?
• are you planning to leave your money in your RRSP for 10 years, and pulling it out for a mat leave or schooling, or for 20, 30, 40 years?
• are you sure that you won't end up a "futile saver" with 100,000-200,000 in an RRSP? (people in this case lose more on surtaxes and the like when they withdraw the money than they gained by having it grow tax free)
• will you "gross up" the RRSP contribution - borrow 3k from somewhere, deposit 13K, get a 3K tax credit for depositing 13K, then pay back the loan, all over the span of a month or two?

Assume that you will gross up the RRSP - do the math to work out the amount you should deposit to get back a tax credit that equals what you borrow - then run a compound interest calculator to work out the interest it will earn over 20 or 40 or whatever years, then tax the principal and all the accumulated interest just once at what you think your marginal tax rate will be when you're retired to see what will end up in your pocket years from now.

Alternatively imagine putting it in a TFSA - you don't get the tax credit so don't gross up, but you won't pay tax on the interest or the principal when you remove it. This is also the most liquid of your three options. And while it uses up TFSA room, if you withdraw you will get the room back, which does not apply to RRSP room.

For the mortgage, you have to look not just at the interest on the 10k, but assuming your mortgage payment doesn't change, every month you'll now be paying down more principal. Use an online calculator to assess the impact (over the entire 25 years of the mortgage) of doing that.

You have a very low interest rate on your mortgage and the lump sum is a small fraction of the principal, so my guess without doing the numbers is that the RRSP or TFSA will win. If you plan to have an enormous RRSP, and you're in your 20s now, go RRSP. If you're barely saving at all, and you're in your 40s now, forget the RRSP and go mortgage or TFSA depending on your liquidity needs. (Some people will do better having it locked in the mortgage so they won't take it out to pay for a vacation; others might need to get $1000 out for car repairs to enable them to keep their job.)