RRSP vs Debt Repayment – A Case Study
Angela is a 45-year-old advertising executive, with a mortgage, car loan, and comfortable lifestyle. Angela’s company has agreed to start paying her an annual bonus of $20,000. After paying her mortgage and car loan, Angela is comfortable with the lifestyle provided by her base salary and wants to know what to do with her bonus to give her the best financial advantage. She wants to know if she should use her bonus to pay down her mortgage, pay down her car loan, or if she should save her bonus in her RRSP. Angela’s father says she should do what he did and pay down her mortgage as soon as possible, to save the interest. Her best friend, Suzie, is suggesting she pay off her car loan since it’s her smallest debt, then apply the amount she was paying on her car loan to her mortgage. Angela’s investment advisor is recommending that she put her bonus into her RRSP to reduce her income tax and save for her retirement. Her dilemma is that she trusts all three people giving her advice and each makes a good argument for their suggestion.
One of the best ways to determine which option provides Angela with the best financial advantage is to create three financial planning scenarios and see which one improves her net worth the most. Of course there is more to financial planning than just numbers, but knowing the numbers is a good place to start when making an important decision such as this. Let’s look at the facts:
Income Assumptions:
- Salary $120,000 indexed to inflation at assumed rate of 3%
- Bonus $20,000/year
- Marginal Tax Rate 43.41%
Mortgage Facts:
- Balance owing $547,000
- Interest rate 2.69%
- Monthly Payments $2287.42
- Renewal December 01, 2022
- Prepayment options: Any amount without penalty
Car Loan Facts:
- Balance owing $32,000
- Interest rate 5.65%
- Monthly Payment $688.08
- Prepayment options: Any amount without penalty
RRSP Facts:
- Balanced Growth portfolio
- Expected rate of return 5%
- Contribution Limit $158,000
Dad’s advice: “Pay down your mortgage to save the interest.”
Angela’s dad has not had a mortgage for many years and when he did the interest rates were much higher than they are now, so it might have made sense to pay down his mortgage at that time, but is this good advice for Angela now? Let’s work out the financial benefit of taking this advice. One thing she needs to consider is that if she takes her bonus in cash, she will have to pay tax on it, which means she would only receive $11,318 after tax. In this scenario, Angela would apply the after-tax bonus amount of $11,318 to her mortgage and would increase her mortgage payment by an additional $8,257 per year once her car loan is paid off. In this scenario, we will also assume that once Angela has paid off her mortgage, the entire payment that she had been making each year will be invested in her RRSP savings. In this scenario Angela would have an after-tax net worth of $1,394,897 at age 65.
Best friend advice: “Pay down your car loan first.”
The strategy of paying off your smallest debt first is known as the debt-snowball method, whereby you make minimum payments on your largest debts and concentrate on paying off your debts with the lowest balances first. Once the lowest balance debt is paid off, you add the amount you were paying against it to the next lowest balance, creating a snowball effect as your payment amount continues to increase for each debt as the previous debt is eliminated. This option often makes people feel better since they feel like they are accomplishing something by eliminating debt balances. Once again, Angela will only have $11,318 after-tax from her bonus to pay down her car loan. In this scenario we assume that Angela applies her bonus to her car loan and once the car loan is paid off the bonus gets added to her mortgage and once her mortgage is eliminated, she invests the ballooned mortgage payment into her RRSP. If Angela were to follow her friend’s advice, she would have an after-tax net worth of $1,395,631 at age 65.
Advisor advice: “Put your bonus into your RRSP.”
If Angela follows this advice she will be able to deposit her full bonus of $20,000 to her RRSP. This will result in an immediate tax savings of $8,682 since she will not have to pay tax on her bonus when it’s earned and can invest the entire amount. In this scenario, Angela will continue to make her regular car payments until her car loan is paid off at which time she will apply her car loan payments to her RRSP investments. Using this approach, Angela’s after-tax net worth would be $1,594,463 at age 65.
Summary
After reviewing all three options it’s clear that Angela would have the greatest financial advantage by investing her bonus in her RRSP. By implementing this strategy each year Angela would have an increased net worth of almost $200,000 over the other two options by age 65, however there are other factors to consider that could have an impact on her decision. What if mortgage rates go up in the future? What if her RRSP investment earns less than the 5% she is anticipating? What if she needs money in the future for another car, renovations, emergencies or even opportunities? Does having debt cause her stress? These are all good questions for Angela to consider before making her decision. In Angela’s situation, the best choice for her may be to take a balanced approach and save some of her bonus to her RRSP and use the balance to pay down her car loan or mortgage. Whatever decision Angela makes about her bonus this year, she will need to review her situation again when the next bonus becomes available to determine the best course of action at that time considering any variables that may have changed.
The key to effective financial planning is understanding that your plan is unique to you and needs to be updated on a regular basis to account for any changes in your circumstances, goals and objectives and any variations from the assumptions used. Good financial planning will provide you with the information needed to make informed financial decisions that will help you achieve your goals.
About the Author
Brad Giroux
As Vice President of DJB Wealth Management Inc., Brad is a firm believer in holistic planning, through a seamless integration of accounting, financial planning, investment management, and risk mitigation.
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