If you are having trouble prioritizing how best to allocate your money this RRSP season, don’t be alarmed. We may be in the homestretch now but that does not mean you have missed your opportunity to maximize your savings and keep on the path towards achieving your goals.
Whether it’s due to a lack of knowledge, undefined or unclear financial goals or numerous pressing monthly expenses, a common dilemma Canadians face this time of year is deciding which of their competing financial priorities – monthly bills, child education and/or retirement savings, debt repayment, etc. – to address first.
There are numerous reasons why people may decide not to contribute (or maximize said contribution) to an RRSP every year. Retirement, especially for young people, is often viewed as a distant concern for our future selves to worry about. The seeming remoteness of retirement is often reason enough for people to place saving for it at the bottom of their list of priorities. Add a mortgage and/or child(ren) into the mix and suddenly there are numerous competing priorities your money can be used to address instead.
Financial advisors often assist clients who face this exact dilemma, especially where mortgages are involved. According to the 2016 Canadian census, “63% of Canadian families owned their principal residence;” meaning a significant percentage of those families had a monthly mortgage payment. People often think by contributing extra towards their mortgage (instead of to an RRSP), they’re effectively reducing the lifespan of their largest debt burden and freeing up savings opportunities later in life.
Though not untrue, the advantage of contributing to an RRSP earlier is that you give compound interest time to work its magic. Consider a $131,070.00 mortgage at 2.89% interest with an amortization period of 25 years. The $613.00 monthly mortgage payment equates to an annual payment of $7,344.00. Paying an additional $166.67 per month ($2000 per year) towards the mortgage principal results in shaving 5 years and 2 months off the mortgage amortization period. Sounds great right?
In this scenario, waiting until later in life to contribute the now freed up mortgage payments of $9,344.00 per year into an RRSP (with a return of 5% for the 5 years and 2 months) equates to an additional retirement savings of $72,186.00.
Now consider the compound interest of an annually recurring, $2,000.00 RRSP contribution subject to 25 years of compound interest growth at a rate of 5%. The result is $97,624 of savings. That is over $25,000.00 worth of savings the person in this example is unknowingly forgoing by deciding to pay off their mortgage debt 5 years sooner. Higher average rates of return in the RRSP account over the 25 years will amplify the potential lost savings. An 8% rate of return, for example, results in over $151,000.00 of lost RRSP value.
If a client must make a choice about how to allocate her or his savings dollars, financial advisors recommend asking this question: “is my money making more by being invested than the amount my debt is costing me?” In the above scenario, the person whose money is accruing 5% compound interest on their RRSP contributions is gaining more than their mortgage debt is costing them at 2.89%. We are currently in a historically low interest rate environment which means the cost of having a mortgage (for longer) is relatively cheap. The compound effect of investing in an RRSP is more beneficial, as far as our fictitious person is concerned, even if it means a small portion of their savings will be put towards a mortgage payment while nearing or even during early retirement.
For many Canadian parents, childhood education savings is also a top contender when it comes to competing savings priorities. Parents want to do what they can to ensure children are set-up for success and nowadays, that tends to translate into post-secondary education. RESP savings are important, but they should not take precedence over making yearly contributions to an RRSP, especially not when young people have the option to work a part time job or take out a low interest rate student loan when the time is right. Having conversations with children about how they can be apart of financing their own education are not only crucial for cultivating financial literacy, but also for establishing expectations that are financially healthy for the entire family.
It is true that compound interest requires years to be maximally beneficial and the earlier a person can start contributing to an RRSP, the better. It isn’t true however, that she or he must pick retirement savings over everything else. With the upfront tax benefit, RRSP contributions also provide opportunities to address other savings goals, like paying down a mortgage or contributing to an RESP, while still putting retirement and long-term financial wellness first.
For help determining how best to prioritize your savings
goals and maximize the value of your dollars, connect with us.