By Calum Ross
In a society where financial education and free financial resources are readily available, it’s hard to believe that most people don’t know how to use their cash flow and capital effectively. When determining many people’s top financial objectives, a large number of people put building their net worth and paying off their mortgage at the top of their list. While at face value these seem rational choices, these goals may contradict one another, and being mortgage-free can be a detriment to building net worth.
With rates of returns in the equity markets once again showing positive returns, RRSP contributions and investments are once again a hot topic. The challenge that this presents for most individuals is clear – with a finite income, how does one allocate capital to acquire that net worth figure that brings you to the point where work is something you choose to do rather than need to?
The RRSP-versus-mortgage debate has long been the source of controversy. While there is no definitive answer, here are some rules that will enable you to make an informed decision. The major factors influencing the choice of options are the mortgage interest rate versus the expected return in the RRSP, the investment time horizon versus the mortgage time horizon, the availability of RRSP contribution room, and the ability to capitalize on mortgage prepayment privileges.
Given an expected RRSP return equal to or greater than the mortgage interest rate, and an investment time horizon equal or greater than the likely mortgage life, maximizing RRSP contributions generally maximizes net worth because the tax-sheltered growth of an RRSP means you get compounded growth for a long period. Conversely, as the mortgage interest rate is greater, or the investment time horizon decreases, it becomes more attractive to prepay the mortgage.
Those fortunate enough to have used up their RRSP contribution room should look at whether borrowing to invest outside of RRSPs is wise. While all the same principles stated above apply, there are a couple of distinct elements to review. When considering building an investment portfolio outside of your RRSP, compare your after-tax rate of return relative to your after-tax cost of borrowing. Generally, if you borrow to invest, the interest borrowed on that money becomes tax deductible. This means the real rate of interest to the borrower becomes one less your marginal tax rate percentage times interest rate on the money borrowed. For those in the top tax bracket, this can reduce the cost of borrowing by 50 per cent.
Next, determine your after-tax rate of return. When investing outside of RRSPs, not all investment income is treated equally for tax purposes, and the difference depends on your personal tax bracket. To optimize your after-tax rate of return, seek capital gains first, dividend income second, and interest income third.
A common misconception is that wealthy people do not have mortgages. Odds are if you know a wealthy person without a mortgage then they likely inherited their money, do not have a good financial adviser, or are highly risk averse. With interest rates where they are today, paying off your mortgage is, in all likelihood, not a wise financial decision if your hope is to have the highest and best use of your capital.
Take solace in this – the next time you are at a party and someone smugly tells you that they have paid off their mortgage, odds are they know little about personal finance and will likely limit their personal net worth as a result. After all, who really worries about a mortgage of a couple of hundred thousand dollars when your investment portfolio is a couple of million dollars and could be used to retire your mortgage any day you choose? By deploying this strategy, what you are doing is using other people’s money to build your net worth.
Calum Ross is senior vice-president and practicing mortgage agent with The Mortgage Centre. He has appeared on Canada AM, Investment Television, BNN and Citytv. He holds an MBA in finance and is an Accredited Mortgage Professional. He can be reached at 416.410.9905.