Financial Planning – Elsewhere

A bit of a timely post on the Freakonomics Blog. The study looked at American finance but it is probably applicable throughout most of North America and Europe:

The most worrisome finding is that many people do not seem well informed and knowledgeable about their terms of borrowing; a sizable group does not know the terms of their mortgages or the interest rates they pay on their loans. – via Freakonomics

A week ago I wrote about Financial Planning.

Financial Planning

Every financial planner (Canadian) I’ve talked to or read has recommended investing in RRSPs. This advice still applies even if you owe money on a mortgage, line of credit and/or credit cards. We do have two RRSPs: one with the locked in amounts from when I was contributing to employer plans and another where the money can be withdrawn at any time. The employer plans were not optional and the funds will not be accessible to us until I reach age 60. The reason we have the second plan is it’s a convenient way to have a fund set aside for a significant financial emergency.

The thing with this financial planning advice is that it isn’t the best use of your money. The Canadian tax system even has incentives built in which make it advantageous in the short term to invest in RRSPs while you have a mortgage. Depending on one’s tax bracket, the short term tax incentive ranges from a one time credit of 25-40% of the funds deposited in a RRSP. That sounds like a really great deal in a financial market where savings interest rates are less than 5%.

Essentially, you are giving the RRSP holder money which is lent back to you as a mortgage at a higher interest rate. The interest rate spread between mortgages & RRSPs over the last few years has been about 3.5%. For the life of a mortgage & RRSP, the mortgage is collecting 3.5% more interest than the RRSP is paying.

When we bought this house, we still had the house (and mortgage) in Miramichi. The only choice we had for a mortgage was 25 years. While we were paying both mortgages, there wasn’t much room for contributing to an RRSP. Once we sold the house in Miramichi and did a bit of planning we switched our mortgage here to bi-weekly payments. Our mortgage allows up to double payments without penalty.

For the last 3 years, we have been paying an extra $42 in each bi-weekly payment. Yesterday, I did the math & those 78 payments of $42 has saved us over $10,000 in interest on the mortgage. The first $42 saved us 24 years of interest at the mortgage rate. In terms of retirement savings, we have gained the 3.5% for 24 years. The next $42 we pay will save us 21 years of mortgage interest and gain 3.5% for 21 years.

There will be a point where the tax incentive makes the RRSP truly more advantageous. In another 5 years or so I’ll probably run some formulas to figure out when we should switch. At a guess, though, I would say the tax incentive only become the best choice in the last 5 years of the mortgage.