Houses on Coins

Even though I make my living as a freelance writer, I’ve always been fascinated with numbers. Some may say that I become obsessed with them, which is why it is a little curious how I didn’t end up with a career in finances, economics, or accounting. And it is around this time of year that, whether or not you have an interest in numbers, you have to deal with them. It’s tax season.

For me, this means going through the books of my freelance writing business, but it also means dealing with my personal finances. As you may already know, 2011 was a monumental year for me as I finally entered the demographic known as home owners. And with that came a mortgage. And with that came more complexities and more decisions.

The good news is that I do have some “extra” (and I use that term very loosely) money around and I wanted to see what was the best way to handle it. One decision that many Canadian homeowners face around this time of year is whether the “extra” money should be put toward paying off the mortgage or if it should be invested into a retirement fund via an RRSP. So, which is the sounder decision?

Buy More RRSPs If…

Even though your personal income tax return isn’t due until the end of April, you only have until the end of February to buy more RRSPs for the 2011 tax year. That’s the same kind of RRSP deadline we’ve seen for previous years.

There are several advantages to investing in your RRSPs. You’re saving for your retirement, to be sure, but you also “save” on your current income taxes. The tax liability doesn’t disappear, but it is deferred and the assumption is that you’ll be in a lower tax bracket upon retirement. That said, does it make sense to invest in your RRSPs in lieu of putting that money toward paying off your mortgage?

If you have “extra” money, you should invest that in RRSPs if doing so triggers a larger tax refund and if the expected rate of return on your investment is higher than the interest rate you are currently paying on your mortgage. If you are reasonably confident that you can earn a 5% return, for example, and your mortgage is currently at 3%, then it is a sound decision to invest in your retirement.

Pay Down the Mortgage If…

When, then, is it appropriate to pay down the mortgage in lieu of putting that money toward buying RRSPs? First, if buying those RRSPs only has a minimal impact on the size of your tax refund, then I wouldn’t bother. Not surprisingly, the other huge factor is the difference between your expected rate of return on your RRSP investment and the interest rate on your mortgage.

If the mortgage interest rate is higher, then you should focus on paying down that debt. It doesn’t make sense to “earn” a 2% return on your investment product, only to pay 3% interest on your mortgage. This also assumes that your mortgage allows for lump sum payments, above and beyond your regular payments. If you have outstanding debts with a higher interest rate than your mortgage, as would be the case with credit card debt, then you should focus your energies on paying those down first.

As Always, It Depends

In my case, even when we bought the house, I made a conscious decision to remain reasonably liquid. That’s because I still needed the cash on hand to pay for my wedding and I expect to have a few other major purchases related to my house in the next couple of years. As such, I want to have enough cash on hand to deal with these expenses, as well as a rainy day fund for “in case” purposes.

Given the current volatility of the market and the relatively low interest rates, I’m likely going to put some of that “extra” money toward the mortgage and leave the RRSP cap room for future investment. Keep in mind that I am no financial expert and your individual situation will surely vary. If you’re not sure, check with someone with more expertise and who has your best interests at heart.