Gosh, what an awful time to have to invest in an RRSP. Not that I'm saying don't do it. Just commiserating.
But on the bright side, that means there is finally something really good about being burdened by a mortgage. And it doesn't matter whether house prices keep rising slowly, shoot up in a bubble or if the bubble pops and they move in the other direction.
Let me explain.
Rule No. 1 of investing in RRSPs is "Don't lose your money." Essentially, there are two ways to win from an RRSP. The first is a straight bet that you will one day be poorer than you are now. The other is a tax break on your sheltered earnings.
The RRSP advantage
The first advantage of an RRSP reminds you of the old life insurance joke: "You bet you are going to die. The insurance company bets you are going to live. And you hope they win."
In the RRSP case, you hope you will get richer and richer as you get older but are betting that you won't. You are betting that, with a lower income in retirement, you will pay less tax on your sheltered savings when you pull them out of your RRSP account than you saved on your taxes when you put the money in.
The second major advantage of a tax-sheltered savings plan like an RRSP is that compound interest and capital gains can accumulate tax-free between now and retirement. If the investment shrinks, all you are doing is sheltering your losses. And in a tax-savings vehicle, that's crazy, because you don't pay taxes on losses.
The trouble is, right now, "Don't lose your money" is not such an easy rule to follow. Not with any certainty.
Safe vs. risky choices
In general, there are two kinds of RRSP investments. Safe investments that pay low interest and risky investments that may fall in value. Currently, neither is a sure thing. The safest investments — like GICs and the best-quality bonds — pay very low interest rates. That means safe investors suffer from the "real rate gap."
Real rates are not something we talk about a lot because during times of moderate inflation, they don't really affect our daily lives. Especially for working stiffs. You earn money, then you spend it. And in general, while prices rise over time, incomes rise at about the same rate.
But when you are tucking away cash with the plan of spending it 20 years from now, suddenly, everything changes. Real rates really matter.
Losing money while you save
The real rate means the difference between what your money will buy now and what it will buy a year from now. To find out whether you are winning or losing on your investment, you calculate how much you earned in dollar terms and then subtract the rate of inflation.
Right now, short-term GICs are paying well below the annual rate of inflation. Longer-term GICs pay a little more, but if interest rates rise, you will likely be stuck well below the rate of inflation over the investment's term. The final result? Safe investments are losing you money.
So, what about putting your money in stocks? Odds are, in the very long term, they are going to go up. But clever people are warning that stock returns are not going to be good over the next decade.
If you have a mortgage, rather than choosing between a pittance and a nerve-wracking risk, you have a third choice. You can make an absolutely safe, tax-free investment with a guaranteed rate of return by paying off your mortgage.
Certainly, it is best to buy a house that you can afford. And, of course, it is always possible to sell your house and buy something smaller, using the difference to pay down your mortgage. But if you already have a mortgage, there is only one way out: you have to pay that money.
Also, the money you owe on your mortgage does not change with the value of your property. Whether the value of your house doubles or falls by half, the money you owe on your mortgage will always be with you. In most parts of Canada, even if house prices tumbled enough that selling your house would not cover the cost of your remaining mortgage debt, you would still owe the balance.
All this means that if you have a big mortgage, at RRSP time, that makes you a very lucky person.
The profits of paying it off
All the banks have mortgage calculators. But my favourite is Karl Jeacle's. That's because by entering a dollar figure in the extra payments section, it shows you how much your mortgage shrinks every time you pay a little extra down.
Every mortgage is different, and you can use the calculator to find out your own rate of return, but here is one example:
If you add a one-time extra payment of $5,000 during the first year of a $200,000, 25-year mortgage with a four per cent interest rate, it shortens the length of your mortgage payments by an entire year. In other words, a $5,000 pay-down in the mortgage earns more than $12,600 in tax-free cash that the mortgage holder would otherwise have to pay.
If you have a four per cent mortgage, it means you are effectively getting a safe and reliable four per cent on your money — and potentially more if rates rise, which they are likely to do since, as these historical charts show, mortgage rates are already hovering around a 40-year low.
I say this pay-down "earns" — rather than "saves" — you money, because unlike what you "save" by buying a dress or suit jacket on sale, this is real money in your pocket. For every year you reduce your mortgage, it is like being (in the case above) $12,600 richer, and since you are not used to having it, you can pour that cash into a tax-free account.
The down side? Paying down your mortgage is only a temporary solution. Paying extra cash on a mortgage every year makes it disappear fast. The more you pay, the sooner you will have to make the difficult decision about where to invest your hard-earned retirement nest egg. RRSP or TFSA? Safe investments or stock?
But for now at least, if you have a big mortgage, you are one of the lucky ones.