Million Dollar Journey

1. 1. Canadian Dream

   What did everyone write on this one this week? I have to admit I like to see other people take on the idea.

   Thanks and keep up the good work!
   CD

   Apr 4th, 2007 @ 11:25 am

2. 2. FrugalTrader

   C Dream, LOL, funny isn’t it? I had this in my post que for almost a week now, and it’s surreal how many bloggers are posting on the topic around the same time. I guess great minds think alike? ;)

   Apr 4th, 2007 @ 11:29 am

3. 3. Middle Class Millionaire

   ha ha ha. I had one ready to go also…maybe I’ll save it for the summer…Cheers.

   Apr 4th, 2007 @ 12:14 pm

4. 4. Canadian Capitalist

   CD: You should allow us to comment on your blog without having to register.

   FT: I am starting to lean towards the idea that paying down the mortgage is superior unless you are willing to construct a properly diversified, low-cost, portfolio. The reason? According to many studies, most investors earn nowhere near market returns. If investors behave in the future as they have in the past (no reason to believe they won’t), a 5% after-tax return sounds darned good.

   Apr 4th, 2007 @ 3:23 pm

5. 5. FrugalTrader

   CC: Paying down the mortgage is definitely a safer bet as it is a guaranteed after tax return on your money. Although, choosing between the RRSP and Mortgage, really depends on the ability of the investor. If the investor can sit through rough times and keep their eye on the big picture, the the market will certainly outperform the low interest rate environment like today, especially if the funds are in a tax free account. But again, that is just my opinion.

   Apr 4th, 2007 @ 3:33 pm

6. 6. Canadian Dream

   CC,

   I removed the anonymous comments do to spam issues. The side effect of that is with the Blogger platform is you have to register to leave a comment.

   My thoughts were most people use one of Google’s services so that can use that ID to sign into Blogger. Hence creating a account should not be a problem and doesn’t even require the person to learn a new ID or password beyond the first Google account.

   My only other option to control the spam is to moderate ALL comments, which would result in serious delays between submitting a comment and getting it posted.

   So in the end I picked the lesser of two evils in my mind.

   Please email me if you would like to discuss more.

   CD

   PS- FT, sorry for this comment being completely off topic, but I felt I should address CC’s question where he asked it.

   Apr 4th, 2007 @ 4:05 pm

7. 7. Mike

   I see nothing wrong with trying to split your money between paying down the mortgage & doing rsp contributions in whatever ratio suits you.

   As CC mentioned the risk/reward profile is very tempting for mortgage paydown ie just over 5% guaranteed at the moment. On the other hand if you are a high-tax person then it’s harder to pay down the mortgage if you are paying 45% of it out in taxes whereas 100% of the gross pay can go into the rrsp.

   CD: I don’t have a google account and I wanted to share my brilliant thoughts a few times on your blog but I couldn’t (and now I can’t remember the thoughts so they probably weren’t that brilliant).

   Apr 4th, 2007 @ 4:43 pm

8. 8. Mike

   One other point to mention:

   FT: I agree with you that over the long term (ie over the life of a 25 yr mortgage) a disciplined low cost passive investor should get a better return than the current mortgage rates (~5%) however there is the possibility that the interest rates could go up which would change the equation. Also - when I think of long term expected returns I might pick a number like say 7% for equities. If the time frame is 20+ years then I might have some confidence that my estimate might have a reasonable chance of being somewhat accurate. But if you’re comparing equity returns to a mortgage - what if your mortgage only has 10 years to go? Can I still say with the same certainty that my estimated equity return will be 7%?

   I would say for shorter time periods (let’s say less than 10 years) you really can’t estimate the equity return at all because it’s too volatile over shorter time periods.
   Anyways, I think the point I’m attempting to get at is that the shorter the mortgage term, the argument that equity returns will outperform the mortgage rate becomes less relevant.

   Apr 4th, 2007 @ 4:47 pm

9. 9. Everyday Weekender

   very good post.. I think its important to first pay off the mortgage.. so its good that there is a different perspective.

   Apr 5th, 2007 @ 12:21 am

10. 10. Jerry

    New to MDJ (from RFD), but personally (without really comparing mortgage vs RRSP or any type of investment), I’d pay off mortgage first
    It is, after all, reducing debt, and guaranteed X%
    And for lots of people, debt reduction or debt-free is a great accomplishment and awesome feeling

    Apr 5th, 2007 @ 1:09 am

11. 11. Chris B.

    I love this debate, and I have something to add to the equation. I normally believe that adding money to a retirement account is more advantageous than paying down a mortgage, but in my case, I’m not sure. My wife and I do not have 20% equity in our house yet, so we have to pay about $62 per month for PMI. I wonder if I should pay down my mortgage until I have 20% equity instead of put more money toward retirement. Any thoughts?

    Apr 5th, 2007 @ 9:36 am

12. 12. Q Cash

    Being debt free is a huge relief, and it makes decisions regarding when to take retirement incredibly easy.

    I, however, always maxed out my RRSPs and used the tax reduction for debt retirement (most times, there were occasions when the refund went to things it probably shouldn’t have ;-)

    The key is discipline.

    On my first mortgage, I did the bi-weekly payments and increased the amount by 10% each year. I felt the 10% increases where within my comfort zone and I was generally making more each year (not always 10% by any stretch, but as I learned to do without the money, I was better able to budget).

    I always treated the mortgage as the cost of living and budgeted accordingly. I did what I could to pay it off, but I also invested in my RRSP.

    It was great to pay off the mortgage AND have a nice retirement portfolio as well.

    Q

    Apr 5th, 2007 @ 7:58 pm

13. 13. Ed Rempel

    Hi All,

    I’ve run many scenarios of RRSP vs mortgage over the years and have found the main determining factor is a huge surprise.

    The top 3 factors in RRSP vs mortgage are:

    1. How much of the mortgage payment will be invested once the mortgage is paid off?
    2. Investment return vs. mortgage rate.
    3. Tax considerations - tax-efficiency of investments and what you do with the RRSP tax refund.

    Just ask yourself - once the mortgage is paid off, how much of the mortgage payment will I invest? If your answer is less than 90%, then RRSP is definitely preferable. Most scenarios require 100% of the mortgage payment to be invested before the mortgage strategy can compete with RRSP.

    We have found that most people that prefer the RRSP are investors, while most that prefer the mortgage are really anti-debt people. We call this the “Sacred Cow”, which is very common in Canada. The belief is that we should pay off the mortgage and then we can spend much of the money and live a comfortable life without debt.

    I often hear people telling me they can retire on almost nothing, since they will have no debt and they won’t be spending much money after they retire. We call this the “Zero Plan” for retirement.

    However, when we go through the cash flow in detail and plan specifically what income they will need to have the retirement they want, their delusions are laid bare.

    If you believe in the mortgage pay-down, ask yourself if you are really just anti-debt - and whether or not you will invest 100% of the mortgage payment once the mortgage is paid off.

    The 2nd most important criteria is the investment return vs the mortgage rate. Considering that mortgage rates are around 5% and should stay low for nearly all of the next few decades (demographic reasons), it is not that hard to beat 5% after tax long term.

    If you don’t know how to do this, email me.

    Canadian Capitalist is right that the average investor makes returns far below average. In fact, the Dalbar study showed over 20 years, the average investor made only 3.5% while the investments they owned made 11%. How can this be? The human brain is conditioned to consistently market time badly. Read some behavioural finance and you’ll find it is hillarious.

    In short, if part of your criteria for buying an investment is that it is currently “doing well”, you will almost definitely earn below average returns.

    However, if you study investment philosophy and hire the world’s best investment managers to work for you - and don’t market time - then beating 5% after tax in the long run is a piece of cake.

    The long run return of the markets is quite consistently 7% over inflation, based on “Stocks for the Long Run” (first book). There are fund managers that beat the markets over long periods of time - and can tell you why. Invest with a few of them and you’ll be fine.

    By the way, a far better strategy is the Smith Manoeuvre. With the SM, you always do both at the same time - pay down the mortgage AND invest. Plus, since the SM requires none of your cash flow, you can still use your extra cash to either pay down the mortgage more - AND invest more, or invest in RRSP’s.

    Paying down the mortgage AND investing is better than just paying down the mortgage OR investing, isn’t it?

    Ed

    Apr 11th, 2007 @ 10:26 pm

14. 15. Nhi

    I like the calculator you provided, but it seems no matter what set of numbers I use, the result always tells me to contribute to my RRSP vs. paying down the mortgage, even if I claim a 15% marginal tax rate.

    Could this be influenced by the fact that Empire Life offers RRSP products and not mortgages?

    Apr 14th, 2007 @ 12:01 am

15. 16. Ed Rempel

    There is a never-ending debate, but the main factor determining which is better is almost always - how much of the mortgage payment will be invested once the mortgage is paid off?

    This is the main factor and is almost always left off of comparisons. For this reason, projections can prefer one or the other, but in practice, the people that pay down the mortgage almost always end up spending most of their mortgage payment once the mortgage is paid off, and end up with very few investments when the retire. This means they get used to a nice lifestyle after the mortgage is paid off, but then have to cut back severely when they retire.

    Here is my observation from working with thousands of clients and prospects. Very wealthy people tend to have high debts. Hardly anyone becomes wealthy without leverage. We find that only the poor and middle class are debt free.

    In the U.S., mortgages are tax deductible, so many people don’t even try to pay it off. 90% of the millionaires in the U.S. have a mortgage - and why not when it is a low rate and fully tax deductible. So, from when they are young, they focus on net worth - not on debt.

    We believe this difference is far more profound than you might think. We think this is the main reason why 1 in 13 Americans are millionaires. It’s true and shockingly high - isn’t it?

    In practice, people we meet that focused on their RRSP’s are almost always way ahead of those that focussed on the mortgage.

    The answer is:
    1. Make your mortgage amortization the same as the time till you retire (so you don’t get used to spending the money in between).
    2. Max your RRSP’s
    3. As FT says, do both by paying your RRSP tax refunds on the mortgage.
    4. Do the Smith Manoeuvre. It easily beats both the mortgage or RRSP strategy.

    Ed

    Apr 14th, 2007 @ 4:04 pm

16. 20. Man From Atlantis

    In my view it is best to pay down the mortgage and then leverage that principal payment back into an investment. Don’t make any RRSP contributions while you have debt that is not tax deductible. Your RRSP room will grow and when/if you sell off your leveraged investment you can deposit some to the RRSP - keep deferring tax. If you are not comfortable leveraging then do the RRSP and mortgage.

    Aug 5th, 2007 @ 1:37 pm

17. 21. nobleea

    There’s a really good online calculator at taxtips:

    http://www.taxtips.ca/calculators/RRSPvsMtgCalc.htm

    It might help make the decision easier.

    Jan 11th, 2008 @ 1:50 pm

18. 22. DAvid

    The debate continues at Yahoo.ca, where Duncan Hood claims the Mortgage, especially in the early years is the best investment. Once you have reasonably reduced your mortgage, then catch up on your RRSP, rather than buying a bigger house. You can read the article here:
    http://ca.pfinance.yahoo.com/ca_finance_planning/20/rrsp-or-mortgage

    DAvid

    Apr 7th, 2008 @ 11:39 pm

19. 23. FrugalTrader

    DAvid, yes the biggest problem with paying down the mortgage first is the tendency for people to upgrade their housing.

    Apr 7th, 2008 @ 11:45 pm

20. 24. Kris B

    I’ve read alot of comments on here about the RRSP vs Mortgage debate, I’ve run alot of the calculators out there and I agree that normally (if there is such a thing) most people would be better off investing while they pay their mortgage instead of waiting till the debt is gone.

    Now with that out of the way it seems to me there are a few choices on how to invest that have the benefit of paying down the mortgage as well:

    1) RRSP- Contribute any left over money after min mortgage payment and use tax savings on mortgage principal at end year.

    2) Smith Man- Take equity out of mortgage and invest (not-registered), used the interest paid on that investment load as a tax deduction, then put that money also on that mortgage (continue cycle after that)

    I wonder, and have not seen anyone on this website or others mention possible combinations of these ideas?? I am not a financial expert, and perhaps this idea is not possible for legal or other reasons but could you not combine the above two ideas?

    Specifically:

    1) Have a readvancable mortgage- Take your equity out as you pay your mortgage (max payment you can afford like in SM), and invest this equity in an RRSP. Recieve tax refund end year, put that on mortgage, then withdraw equity again and continue the process.

    Now I realize that in this scenario that you would not recieve the interest deduction that you would recieve for a non-registered investment, but instead would recieve the normal return that an RRSP would recieve. As far as I can figure the effect would be recieving a large tax refund in the present (by using RRSP) and smaller in the future, vice a normal SM where you recieve a very small refund at first and larger in the future (on a continual basis I realize until the loan is paid).

    Any comments on this hybrid RRSP- SM idea, I am certain others have considered this option before and knew reasons why it is either worse or not legal than the regular SM, but I’d like to know those reasons. Plse advise.

    Apr 14th, 2008 @ 2:09 pm

21. 25. FrugalTrader

    Kris, as you mentioned, there are a couple issues with this. Lets look at the big picture.

    At the end of 25 years, when the mortgage is paid off, you’ll end up with a large HELOC which is non-ded, along with a large RRSP. If you want to withdraw from your RRSP, you’d have to pay tax at your full marginal rate.

    If you do the regular SM, at 25 yrs, you’ll have a large heloc which is tax deductible, but also a large portfolio which pays you tax efficient dividends.

    I haven’t run through the exact numbers, but it looks like option 2 is more favorable.

    Apr 14th, 2008 @ 2:37 pm

22. 26. Kris B

    Thanks for the quick reply, yes on the surface the regular SM does seem to me to be more advantageous as well, two thoughts in the back of my mind make me wonder though:

    1) Legality of SM: risk that standard SM deduction for non-reg investment interest might be overturned by supreme court. Now I realize this hasn’t happened, and might not. And even if it does you’ll still be able to do it until that ruling comes down, but it is a risk to consider.

    Compared to that, the deductability of RRSP investments is not going anywhere anytime soon, as this is the prime vehicle government supports for retirement. Just a thought, if the interest deductability for regular SM goes away, a powerful tool within it’s arsenal is as well.

    2) Benefits of tax deduction in present current dollars (with compounding) vice future dollars.

    From the calculators I’ve used for an average home mortgage of $185K at prime, and funds above interest of $5-600 a month, that interest would start around 2-3$ per month, rising to 24$ in the first year. As you put $600 on the LOC each month. Over the longer term (5 years) interest payments steadily rise to about $187-200. This shows to me that in the first 5 years of a SM that interest deductions would return only a small amount in the first few years (<5) $70-$400 and rise to be a considerable deduction by the end of the mortgage (15 years) at around 2-3K depending on rates.

    If you used an RRSP for the SM you could average high returns in the first year the same investment ($600 per month), why, well it seems to me because you are recieving the deduction (based on your tax rate) on the amount invested not just on it’s interest. Now I realize this is a one shot deal, once you get this return for a year, you won’t get a return on that amount next year, but you will however recieve an identical return on the new amount you put in your RRSP that year.

    To make it short: recieve a large return (based on investment amount not interest) today and use that to pay mortgage down and re-invest. Or recieve a smaller return that grows each year as interest grows, and use that to pay the mortgage down and re-invest (at an increasing rate, as I’m aware)

    I wonder if someone crunched the numbers on an RRSP-Smith Man if the savings from the RRSP used against the mortgage would retire that loan (on the house only I realize, a large non-deduc loan would still exist) quicker than a regular SM? If so would these increases in compounding, make up for the loss of interest deductability for a investment loan (over the long-term i.e. 25 years?)

    These calculations seem quite complex, do you have a spreadsheet you would recommend for this, or would it require a novel review of this situation. To be clear though, I do suspect that you are right that a regular SM will out perform, but I would like to see a comparision. Maybe if someone has done one already.

    Apr 14th, 2008 @ 3:15 pm

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