Faceoff: Mind your mortgage

Michael A. Healey, B.A., CFP, CLU, CHS, Associate, ZLC Financial Group

Stance: do what lets you sleep at night

I tell clients to avoid debt wherever possible, especially non-deductible debt such as mortgage interest.

Whether or not it’s critical to retire debt-free depends on each client’s personal circumstances and comfort with debt.

While most people in retirement derive income from a combination of pension plans, RRIFs, and government benefits, that combination usually doesn’t add up to pre-retirement incomes. So carrying a substantial mortgage into retirement puts a burden on other lifestyle and retirement goals.

Mortgage or RRSP?

So what do you say to a client who asks whether to put funds in an RRSP or pay down her mortgage?

If it’s an either/or choice, it makes more sense to fund the RRSP, especially for younger clients with longer accumulation periods. Compound interest is a powerful tool—the longer money builds up on a tax-deferred basis within the RRSP, the bigger the ultimate retirement nest egg.

Take a 45-year-old who has $500 per month of excess cash flow and is weighing the option of putting it toward his mortgage versus making additional RRSP contributions. Assume the RRSP hasn’t been maximized in prior years and there’s more than enough contribution room to absorb the additional $6,000 per year.

Windfall wisdom

For clients with low debt tolerance, it may make sense to use expendable cash to pay down or pay off the mortgage.

If you invest a windfall rather than paying down the mortgage, you may do better financially at the end of the day. But if you can’t sleep at night because you’re worried about how the markets will perform, it’s probably a better idea to pay off the mortgage and sleep well.

Financially speaking, it comes down to whether or not the after-tax return on the investment is greater than the mortgage interest rate. But being debt-free, or closer to it, can provide peace of mind. And it’s hard to put a price on that.

That said, given current low interest rates, it’s certainly possible to get ahead financially by making additional non-registered investments and trying to achieve greater after-tax returns (versus paying down a mortgage).

But clients must be clear about the risks involved. If you put your cash into an equity portfolio rather than paying down the mortgage, and we have a repeat of 2008, then the client would lose big. For clients who understand and appreciate those risks, there’s potential to reap the rewards as well.

Source: Michael A. Healey

Let’s also assume:

• Outstanding Mortgage Principal: $500,000
• Mortgage Interest Rate: 4%
• Amortization Period: 25 Years
• Monthly Mortgage Payment: $2,640
• Planned Retirement Age: 70
• Return on RRSP Assets: 6%
• Marginal Tax Rate: 40%

By increasing the monthly mortgage payment by $500, this client reduces overall mortgage costs by more than $165,000, and the amortization period from 25 to 19 years.

Yet, increasing monthly RRSP contributions by the same amount results in additional accumulation of $203,000 over the same period, in addition to about $45,000 in tax savings.

Debt-free faster

In addition to making more frequent mortgage payments (bi-monthly or weekly if possible), some institutions offer hybrid mortgage banking products that shorten amortization and significantly reduce the amount of interest paid.

A hybrid account works like a mortgage line of credit—the outstanding principal is calculated daily based on the inflows and outflows to the account.

So whenever a paycheque or other deposit is made, the amount owing is immediately reduced, and when withdrawals are made, the amount owing goes back up. Let’s say your outstanding mortgage principal is $500,000. If you deposit a paycheque for $10,000 on the 15th, the principal for that day will go down by $10,000; the interest would fall accordingly. Such hybrid arrangements can take years off a mortgage and save several thousand dollars in interest payments over the lifetime of the mortgage.

Secondary residence

Depending on whether one receives rental income from a cottage or vacation property, it may make more sense to carry a mortgage longer as the interest may be deductible against the rental income. But carrying high debt loads into retirement can also result in tighter cash flows. I’m fine with clients leveraging for real estate investment as long as they can comfortably service the debt and are able to absorb potential increases in interest rates. Ultimately, the property should be cash flow positive, or at the very least, cash flow neutral.

Clay Gillespie, CFP, CIM, Financial Advisor & Portfolio Manager, Managing Director, Rogers Group Financial

Stance: Debt, get rid of it now

See-sawing debt

Canadians look at debt as a fixed monthly payment. Interest rates have been so low so long; people don’t realize the risk of interest rates eventually rising. They forget the time when rates touched 19%, and most of their payments went directly to cover the interest.

Once interest rates start rising, they could hit 5% to 6% quickly. That means mortgage payments will go up by 50% to 60%. When you’re working, you can absorb increases in interest rates, but when you’re retired such peaks and troughs directly impact lifestyle.

There’s nothing good about debt in retirement. To pay it off, people are forced to withdraw more money, which pushes them into higher tax brackets. It can sometimes even result in OAS being clawed back.

Unfortunately, debt is seldom high on people’s agendas. As their advisor, you have to make it one of their active financial planning objectives. I tell all my clients to pay down their debts first. That allows them so much more latitude in their later years.

And advice is the same for all clients—high-net-worth or not-so-high-net-worth. Debt is a wildcard. Any market changes could impact it. I can’t guarantee what their retirement lifestyle is going to be if they have debt. That’s as uncomfortable as it gets for a financial planner.

In places like Vancouver, houses are such a big part of people’s total assets. If they still need to pay off those houses, their portfolios need to have a lot more growth. That much risk going into retirement is bad planning.

Taming tax

I have clients who come to me with a million-dollar pension plan and a big debt. That’s a snare because in retirement all this cash flow pushes them into higher tax brackets. And a lot of that money is poured into paying off debt in the first five to 10 years.

Similarly, it makes zero sense to own a stock portfolio and have a pending mortgage. My suggestion: sell the stock and put it against the mortgage. Then, borrow that money back from the home equity and use it to repurchase the stocks. Now you’ve at least made that money tax-deductible. It’s a no-brainer.

There’s nothing grey about this strategy. I use it every time a situation like this comes up. It might not seem like a big deal when interest rates are low, but it makes a lot of sense when they go up.

If people have debt going into retirement, I give them the first five to 10 years to pay it off aggressively. If it lingers beyond that, I suggest downsizing their homes to liquidate that debt.

Mortgage or RRSP?

If you’re saving for retirement, and have RRSP room and a mortgage, the lower your income the more sense it makes to pay off your mortgage first. If, however, you’re in the highest tax bracket, it makes more sense to first top up your RRSP contribution because you’re getting 42% back.

I typically tell people to maximize their RRSPs, and put every other spare dollar into their mortgages. If people have debt, I wouldn’t suggest saving in non-registered investments, not even TFSAs. When you put money into your mortgage, it’s already a tax-free investment. The math stays the same.

For liquidity, I always think people should have lines of credit against their houses. If you need $20,000 for something, it’s better to use that line of credit. Of course, the risk is people might end up using it for lifestyle expenses.

Maximizing RRSP and funneling the refund into the mortgage is ideal in theory but doesn’t always pan out in practice. People aren’t wired to be that disciplined.

I like to make sure clients save along the way, rather than making lump-sum payments off a refund. I build monthly deductions into their plan: put $400 into the RRSP; $400 into the mortgage; and $500 into a high-yield non-registered savings account.

When the refund comes, they’re free to do what they want with it. I personally don’t budget, and don’t expect my clients to do it either. People get used to the money in their bank accounts. If they don’t see it, they don’t miss it.

Kanupriya Vashisht is a Toronto based financial writer.