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Case Study: Retirement Soon, RRSP or Mortgage?

Kayla from PEI emailed me for some advice about her financial situation.  She is 50 with a mortgage and small RRSP.  She’s wondering where she should focus her money as she hopes to retire when she is 55.  Here is more information about Kayla.

  • RRSP Portfolio Value: $6,000
  • RRSP Contribution: $110/month
  • Gross Income: $67,000 (after tax ~$3,220/month) increasing 2.25% per year
  • Mortgage Payment: $504 bi-weekly ($50 to property tax) @ 5.4%
  • Mortgage Balance: $84,000, 10 years remaining.
  • Car Loan: $14,000 @ 5.25% (~$265/month for 5 years)
  • Pension can start at age 55 with annual pension income of approximately: $42,000 per year (after tax ~$2600 /month)
  • Monthly Expenses (not including debt servicing): $1,400
  • Total Expenses: $2,757/month (without RRSP contribution)

With retirement on it’s way, Kayla will have to make a few changes.  I’m of the belief that all debt should be eliminated by the time that retirement starts.  For many, retirement income is fixed, who wants a portion of that income still servicing debt?

Another point I’d like to make is regards to RRSP contributions in addition to pension contributions.  In my opinion, if someone is fortunate enough to have a lucrative defined benefit pension plan, then debt servicing should come before any RRSP contributions.  Once debt is eliminated, I would personally move to maxing out the TFSA, then to the RRSP.  I would go that route because RRSP withdrawals are taxed as income which would be on top of any pension income received during retirement.

Having said that, looking at the financial specs above it seems apparent to me that she should focus on paying down her mortgage.  Even without looking at anything else, paying off the mortgage represents a 5.4% guaranteed after tax return which would be challenging to find anywhere else.  Once Kayla eliminates her mortgage, she will free up about $1,000 /month in cash flow (she’ll still have to pay property tax).  Should Kayla take her $110/month RRSP contribution and put it directly on her mortgage payment, her mortgage amortization would reduce to 8 years. If she really want to retire in 5 years mortgage free, she would need add $300 to her bi-weekly payment.

If Kayla turned 55 today, her car payment would be gone but a mortgage payment would remain.  Her total monthly expenses would be about $2,500 with a monthly income of approximately $2600.  Too close for comfort especially if inflation is added to the expenses over 5 years.  However, when the mortgage is paid off, the monthly expenses would reduce to $1,500/month leaving a healthy cash cushion.  To add to the picture, when Kayla turns 65 and assuming she qualifies, she’ll be eligible for Old Age Security which would give her another$516 /month (in today’s dollars).

In conclusion, it may be in Kayla’s best financial interest to pay off all debts before calling it quits.  It will give her a more comfortable retirement and perhaps peace of mind.  If Kayla were to simply redirect her RRSP contribution to her mortgage, then she could join the retired club in as little as 8 years.  Not exactly freedom 55, but freedom 58 has a nice ring to it too.

Back to you, how would you advise Kayla about her financial situation?

Disclaimer:  I’m not a financial advisor, anything written in this post should be used for informational purposes only.

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 27 comments… add one }
  • cannon_fodder November 25, 2009, 10:11 am

    What about taking early CPP at age 60? Does Kayla have a statement of CPP contributions which might give her a sense as to another income stream?

    Getting aggressive with paying down the mortgage sounds like a good idea. Perhaps a year before retirement begins she could renegotiate her mortgage to lower the monthly payments to provide more of a cushion. With the addition of withdrawing minimal RRSP holdings of $150/month (assuming growing to $8,000 by the time Kayla hits 55 and then 5% growth after retirement), that should last until about age 60 at which point the CPP could kick in and help manage the difference between the pension income and other expenses.

  • FT FrugalTrader November 25, 2009, 10:26 am

    CF, I believe that CPP is built into most defined benefit pension plans. In her case, there would be a bridge benefit between her retirement age and when CPP officially kicks in.

  • Four Pillars November 25, 2009, 11:36 am

    It’s hard to argue against paying down debt. She has a lot of debt for her age and desired retirement age.

    RRSPs are great and all but in her case with the good pension then the rrsp benefits are much less than for someone without a pension so I agree – forget about RRSP contributions and pay down the debt asap.

  • Observer November 25, 2009, 12:26 pm

    Depends on the details of her car (current value, driving needs, etc) but is she prepared to trade down on her vehicle? If she is not upside down on her car loan and could drive a clunker, she might liberate some cash that way. Needs a bit more detailed thinking since question is how long an older used car would last and when it would need replacement.

    By the way, MDJ, are you sure she would need an extra $300 biweekly to retire her mortgage in 5 years? I don’t have a calculator/spreadsheet to check right now but would have ballparked $300-400 per month. I may be wrong.

  • DG November 25, 2009, 12:28 pm

    It’s too bad her mortgage rate is as high as it is…and I assume it is locked in for a while.

    Perhaps get a HELOC at 3.5% and use it to pay down the mortgage as much as terms allow. Same for the car. A small interest savings, but perhaps not worth the extra complexity and risk.

    Dan.

  • FT FrugalTrader November 25, 2009, 1:24 pm

    Observer, I used the mortgage calculator on Dinkytown – as to whether it’s accurate or not is another story.

  • Kayla November 25, 2009, 1:35 pm

    Thanks all for your feedback.
    I was unfortunately in the position of Divorce several years ago and after working hard to sock away a substantial amount of RRSP and equity in my home,,, I lost it in the divorce. So had to remortgage 6 years ago up to the 25 year. I have worked hard to get it to owing 10 years now and that has been my focus.
    So yes, I do have a lot of debt at my age, but not for extravagance!
    I drove a clinker for 5 years without a payment and finally had to break down (excuse the pun for that is what the old clunker was doing often!) but the new to me car will last me well beyond the payments. I hope! I was going to just get an older clinker,, but throwing bad money after good was not the route I chose.
    I have been working on paying off that debt earlier than the 5 years as well.
    Frugal Trader was right about my CPP bridging.
    Thanks for all the feedback and assessments. It has been great to have others opinion .

  • Beth November 25, 2009, 1:53 pm

    @ Observer — If she trades in the car for a clunker, won’t she just have to buy another one after she retires, and thereby incur debt in retirement? Would it make more sense in the long run to keep paying off the current car and drive it for as many years as possible?

    If age 55 is a deal-breaker, what about picking up some part time work after retirement? Based on the numbers, I wonder if Kayla is a teacher. In which case, supply teaching may be a great way to earn a bit of income on the side until she pays off her debt. (If she isn’t a teacher, maybe part time freelance work or consulting?)

  • Kayla November 25, 2009, 2:05 pm

    I am able to work until I chose. I am able to retire at 55,, but likely wont be in the position to do so, so can work for years beyond. FrugalTrader has it more down to another 8 years as opposed to my hope to of 5,, unrealistic I know. 8 is doable. After working for the past 26 years ,, it would be NICE to be able to Freedom 55,, but Freedom 58 is a better goal it seems.
    I agree with you Beth about my car! Seems a better bet for me.

  • Graham November 25, 2009, 4:24 pm

    I like DG’s suggestion. The only problem is that it costs about $600-$700 to register a home Equity Line of Credit [HELOC]. But it might worth the “one time” cost.

    She could move her car loan to the HELOC and then borrow against her HELOC to “double-up” on her mortage to pay it down without penalty, while using the “redirected’ $110.00 [her current contribution to RRSP] to service her HELOC along with her current “car payment”.

    But she will have to be cautious because interest rates [while they will probably remain for another year or so] could rise.

  • Kathryn November 25, 2009, 5:20 pm

    Kayla: First off, let me say how sorry I am about your divorce. From the sounds of it you’ve been good with your finances for your working life and the divorce set your plans back a fair bit. From what you say, it sounds as if you lost most of what you had put away in your RRSPs and a good chunk of equity in your home. I only hope the divorce settlement was fair to you both. From what you write, it sounds as though it may not have been equitable.

    I agree with FT that your mortgage debt should be your #1 priority. Paying off that mortgage before you retire will buy you a lot of financial freedom in your retirement years. If you can, pay it off in 5 years but if it means working a few extra years, it will be well worth it.

    I’ve been working with someone in a very similar situation to yours. With her husband gone and her kids moved out, she took in a couple of student borders. She was able to use the $600 a month (two borders at $300 a month each. – They bought their own food) and apply it towards her mortgage.

    I also second the point about part time work. If you are a teacher, supply teaching or tutoring is a great way to ease into retirement both financially and psychologically.

    All the best and thanks for being willing to share so openly with thousands of online readers.

  • Finance_Addict November 25, 2009, 6:09 pm

    I differ slightly on what’s been presented above wrt to retirement date. Ideally and generally I agree that being debt free by retirement is a very good thing. HOWEVER in your case you have a wonderful thing called a defined pension plan. Likely indexed etc. Looking at your numbers you will be able to comfortable support the remaining balance of your mortgage (if any) in 5 years time. It’s clear to me you have been aggressively paying down the mortgage since the divorce over the last few years. I suspect that over the next 5 years you will get rid of most if not all of it. What ever is left in 5 years time will be very small. I agree with FT that you should stop right now putting a single cent into your RRSP..why would you?….remember 2 words defined pension! Continue aggressively paying down your mortgage using lump sums etc. for the next 5 and it’s freedom 55 (not 58) for you!!

  • Bernie November 25, 2009, 6:32 pm

    I’m in full agreement that Kayla should stop making RRSP contributions and instead redirect the money towards her mortgage. It would be a plus if the rate could be renegotiated. Other than that, Kayla has done well with her finances. I’m amazed she can get such a lucrative pension, even with the CPP bridging, considering her current annual income. Well done Kayla!

  • PIttyPat November 25, 2009, 7:49 pm

    Good analysis everyone. Here is another point to consider. Most defined benefit plans also come with a lump sum severance pay or retiring allowance when you retire. Many of us don’t pay attention to this until we are really close to retirement. We need to remember that any severance pay that can’t be rolled over into an RRSP (see http://www.cra-arc.gc.ca/tx/bsnss/tpcs/pyrll/clcltng/spcl/rtrng/trnsfr-eng.html for calculation of how much you can roll over) must be declared as income in the year of receipt.
    By not contributing to an RRSP between now and retirement, you will build up your RRSP room. Then when you get this lump sum you can use what doesn’t qualify for the rollover into an RRSP as a regular RRSP contribution to the extent you have room and/or lump sum left over to offset what must be declared that year. You can also over contribute a cumulative lifetime amount of $2000 to an RRSP without penalty so this “over contribution room” can also be used if need be. Why would you want to do that when we just all said don’t bother contributing to RRSPs? Because if you don’t, the lump sum on top of your salary in the year you retire will likely put you into a higher tax bracket – sometimes two or three levels above normal – and you pay way more tax then you have to. But by purchasing an RRSP with the “left over” lump sum you can in essence defer having it taxed until such time that you are receiving just pension and are in a lower tax bracket. You can be really strategic by paying attention to marginal tax rates and withdraw just enough each year to keep you within the limits of the lowest tax bracket possible. If are debt free at that point, I’d suggest putting your withdrawals into a TFSA if you can.

  • Tom November 25, 2009, 8:51 pm

    She could use a mortgage acceleration program like SmartEquity, pays off mortgage faster without increasing payments. See following:
    http://inlinebusiness.com/cgi-bin/d.cgi/tomvenner/se_ret_08.html

  • Jeff November 26, 2009, 12:20 am

    I like the suggestions above by PIttyPat. I was laid off a few months ago and handed a (nice) retiring allowance. Though I was able to immediately transfer an eligible amount to an RRSP, the ineligible amount certainly did kick me into a higher tax bracket. I deferred a portion of the allowance until next year to reduce the impact, but it would have been nice to have some RRSP contribution room too. Unfortunately, due to a recent Public Service Plan adjustment, I’m in negative (overcontribution) territory

    Not wishing to hijack this thread, as an aside related to the above comment about CPP “bridging” (please explain this term), I’m thinking about taking CPP at age 60. I believe the pension reduction at age 65 will be equal to the amount CPP would have been had I waited until age 65 to start it. I believe this just means I’m drawing CPP earlier, being under the impression this is basically a zero sum game i.e., take more earlier, get less later. Right?

  • Jason November 26, 2009, 3:53 am

    Interesting… first time here… will be returning to see your other ideas.

  • Kayla November 26, 2009, 9:19 am

    Thanks again for all your comments, feedback and suggestions.
    It seems certain that all belief is pay down on mortgage. Makes sense and was interested to see what others would say.
    This verified it for me.
    Now,, to work on my plan!
    Thanks again Frugal Trader and readers.

  • Stuart November 26, 2009, 12:12 pm

    I am of the state of mind that some debt is good debt, especially if it carries a low interest rate. The current mortgage rate Kayla has is very low. Is this a fixed or variable rate and how long is she locked in?

    Even with a defined benefit plan pension, if you have room to top up on your RRSP you should consider maxing this amount out. The income tax implications can be a huge benefit now, especially if you have reached a higher tax bracket. This is because you will have tax free gains within the account while you wait to reach retirement and a further tax savings as you likely move into a lower tax bracket once you actually do retire.

    A home mortgage is good debt as it is cheap money. As long as you can create a return greater than the mortgage rate you are better off through simple leverage. Although most people are concerned about debt, you need to understand the basic implications of opportunity costs and time values of money. Also, don’t forget about your ability to write off interest from you mortgage against your tax return; this is a benefit in retirement as well.

    Kayla may want to take a look at our RRSP vs. TFSA guide which is a series of 3 simple questions that will tell you which account is more beneficial for you.

  • FT FrugalTrader November 26, 2009, 12:18 pm

    Stuart, make sure you get your facts straight. You cannot claim the interest on a mortgage unless it is borrowed from to produce income. As well, her cash flow in retirement will barely be sufficient to cover expenses should she choose to keep her mortgage.

  • cannon_fodder November 26, 2009, 3:22 pm

    Another option would be to look at whether downsizing the residence would be an option in a few years time. I didn’t see any details as to what type of housing Kayla is in now, but in a few years time when retired, perhaps a move into a significantly less expensive residence could be an option.

    I would imagine in PEI there isn’t as large a disparity between homes near the ‘big’ cities and in the far off suburbs as we see in other provinces. When my dad retired, they moved to an area that provided everything they needed within walking distance. Being positioned close to work was no longer a requirement.

    But, the change in housing would have to be signficant because you would have to pay legal fees, commission to sell the house, moving costs, perhaps new window coverings, lights, etc.

    I bring this up because a recent article in the Globe suggested to a single retiree that this was her best option in order to make it through retirement successfully. She was not in as good a position as Kayla, however.

  • Vancity1 November 26, 2009, 4:17 pm

    I have a different take then most on mortgage payments. I think that one should be just the minium towards their mortgage and invest the remaining in RRSP’s, Tax free savings account and other investments.

    I feel that over time my house would apperiate in value, and by the time I’m ready to retire I would not need a big house to live in, so I would downsize to a condo. After selling my house I would pay off the remaining balance and move into a smaller townhouse or condo without a mortgage.

    I’m 27 and own two properties (One primary and one rental) in Vancouver, and if you look at the real estate market it’s nearly impossible to purchase a house in the lower mainland. Currently I’m only making minium payments on both properties but at the same time I’m building equitly and If/when I sell I will walk away mortage free.

    I would like to hear your thoughts on my approch?

  • DG November 26, 2009, 7:23 pm

    Vancity1: If Kayla focused on her mortgage first she would have extra equity when downsizing which could be put into RRSP/TFSA or other… So both approaches yield the same result in many regards.

    But… paying the mortgage first yields a guaranteed 5.4% tax-free return without risk. I don’t think you could get that kind of deal from other investments.

    Dan.

  • Trajan November 27, 2009, 2:10 pm

    I think it could work out retiring at 56.
    Dump the RRSP payments into the mortgage right away.
    Between the lack of car payment, and the extra income she should be able to pay off an extra 885 a month when she is 55. That translates into a total mortgage term of 6 years 4 months.

    After you retire, immediately start withdrawing the RRSP and start putting it into a TFSA. You want to have completly converted it over before you turn 65. Otherwise you miss out on tons of nice government programs. Spreading it out from 56-65 should mean it won’t increase your tax bracket any.

  • Mark in Nepean November 28, 2009, 11:14 am

    Seems pretty clear to me….Kayla needs to reduce debt.

    (She) you should try to have no mortgage in your retirement years.

    Pay-off the house and pay-off the car.
    Any money after that should be put into a TFSA so income/interest earned is tax-free. Contributions to the RRSP would be my last choice; pay/contribute only enough to off-set an income tax payments to the Feds :)

    Given her salary and some frugality, she will be more than fine.

  • PIttyPat November 29, 2009, 4:09 pm

    Jeff – at the risk of getting too far off topic I thought I’d respond to your question about CPP at 60 versus 65. CPP bridging, as I understand it, is a type of “top up” of your pension until you are able to qualify for an unreduced CPP pension at 65. There is a penalty for taking CPP before age 65 and you’ll have to decide if it is worth it.

    Calculation of reduction to federal public servant pension at age 65 due to bridging termination is: .007 x # years of contributory service X average max pensionable earnings for the year of retirement (max $42,500 but use average salary if less than this) = reduction. Example (all in 2009 dollars for illustration purposes) if you had 35 years service and qualify for maximum CPP: .007 x 35 years service X $42,500 = $10,412.50 reduction to federal service pension at age 65. The maximum CPP pension is $10,905 at age 65 in 2009 dollars. So if you wait until age 65 the decrease to your federal pension is about the same as the CPP pension you will start receiving – you just start getting this from two sources (fed pension and CPP) instead of one (fed pension).

    Now lets see how that compares to the CPP benefits you would get if you elected to take CPP earlier:

    Age 60
    Penalty of 30% for taking it early (0.5% x 60 months early)
    Annual CPP payments $7633.50
    Total payments received prior to age 65 are $38,167.20
    Age where reduction in CPP benefits equals $38,167 is 77 years old

    Age 62
    Penalty of 18% (0.5% x 36 months early)
    Annual CPP payments $8942.10
    Total payments received prior to age 65 are $26,826.12
    Age where reduction in CPP benefits equals $26,826 is 79 years old

    [Note – the gov’t is raising the penalty for early CPP with higher rates transitioning in starting in 2012. Not a huge hit in my opinion, especially when you factor in the reduced taxes because of the reduced pension received.]

    You can use your own figures and dates and even get your own quote from HRDC to decide what makes sense to you. For me, I’d rather have the money sooner than later to enjoy, invest, whatever. Plus, who knows what the future brings in terms of life expectancy. I’ve already had one major illness.

    Cheers!

  • Gates VP November 30, 2009, 10:25 pm

    @Kayla: some additional questions:

    Does the $1,400 in expenses currently include:
    – Home maintenance costs? (e.g.: 1% of the value of your home each year) What have you fixed in the last 5 years?
    – Car maintenance costs? (a typical car costs ~ $8k / year according to AAA, that’s a lot more than the $265 / month)
    – All of the insurances you require?
    – Budget for time with a fitness or health professional?
    – Money for your hobbies?
    – Money spent on travel?
    – Money for time with friends?

    I think that the consensus on paying off the mortgage is correct. You can likely “retire” sometime around 55-58.But I think that there are lots of other things to consider.

    For example: you’re single. Most people are not intent on being single from 50 to 85. Does your current budget give you enough money to spend time with friends or prospective partners? I have a couple of family members who hooked-up with new partners in their 50s. One got married. As older couples, they really revel in trips and fine dining. But if you’re not doing those things right now, you’ll have to find that room in the budget.

    You’re going to retire with 20+ years to live, maybe even 30 (say you live to 85). In big ticket terms that’s 3 cars, 3 sets of carpets, 2 interior paint jobs, 30 sets of x-mas gifts, kids (and / or grand-kids) going to University. It’s a long time.

    I have a few retired government workers in the family all in their 50s. One hit the “magic number of 85 on his 55th birthday. He took his pension and started doing side gigs in manual labor. A few months here and there. Mostly to keep himself busy, but he derives an income from these as well. Another moved into “semi-retirement” to just work less and now she’s off to travel and teach English in South America. Another just moved from full-time teaching into part-time teaching. She loves teaching adults, so she just does night courses and gets to travel on the usual school breaks.

    My point here, is that what’s far important than paying off the mortgage or really digging into the “can I retire?” question, is the “what is my retirement?” question.

    Now we can answer the “can I” question. That’s easy. Pay down the mortgage and start collecting a pension. You’ll have enough to eat, clothe and house you until you die. There are millions of Canadians living on less than 2.5k / month.

    The bigger question is really “do you want to live on 2.5k / month until you die?”

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