November 15, 2019

Should you repay debt or add to RRSP?

BY TERRY MCBRIDE

What if you have received extra cash from a year-end bonus or an inheritance, for example? Should you use your cash to repay debt or to contribute to your RRSP? The answer depends on whether your RRSP growth rate exceeds the interest rate on your debt. First, review the interest rates on your consumer debts to find the most expensive debt.

Pay off credit cards Credit cards typically charge 20 per cent interest. Because it is unreasonable to expect your RRSP to grow that fast, you should repay what you owe on your credit cards.

Since you pay the 20-percent interest using after-tax dollars, the benefit of paying off a credit card balance is that it’s equivalent to earning a guaranteed 30 per cent rate of return, assuming you are in a 35 per cent tax bracket.

That means you really should not be making any RRSP contributions if you are carrying any unpaid credit card balance. Fortunately 64 per cent of Canadians pay off their credit cards in full each month.

Low mortgage rates How do today’s mortgage interest rates compare to expected RRSP growth rates? Mortgage rates currently range between about 2.7 and 4.7 per cent. They are lowest for short term and variable rate mortgages; highest for longer term, fixed-rate mortgages.

Borrowing rates could conceivably remain this low for a couple more decades mainly because of the age wave of baby boomers. Many boomers have already retired and many more will retire soon.

Canada has a large proportion of older savers and a shrinking proportion of young borrowers.

Do an Internet search for “David Foot population pyramid.”

You will see graphs for Canadian demographic trends at 10-year intervals from 1871 to 2051. Combine a growing supply of cash to lend with declining demand by borrowers.

That explains why it is reasonable to expect loan interest rates to stay low for a couple more decades.

RRSP growth rates When the RRSP growth rate you expect exceeds the mortgage interest rate you have an incentive to start making RRSP contributions before you entirely pay off your mortgage. Can your RRSP growth rate beat a mortgage rate that is less than five per cent? If you are a risk-averse investor you probably have an RRSP growth rate that is well below five per cent. That is especially true for an RRSP that holds GICs, because GIC interest rates these days are generally lower than three per cent. Yields from marketable bonds were generally negative during 2013.

What about an RRSP that holds a large equity component? The yields from equities have been robust for 2013 – about seven per cent in Canada and more than 20 per cent internationally.

There is a widely cited study called DALBAR’s Quantitative Analysis of Investor behavior, which compares investors’ returns against market returns. The latest DALBAR study shows that over the 20 years that ended Dec. 31, 2012, the average equity investor earned only 4.25 per cent while the market returned 8.21 per cent during the same period. Fear from previous downturns caused investors to sell low while short-term rallies tempted investors to buy high. The average investor times the market badly.

An RRSP investor can beat five per cent by hiring the best investment managers and doing no market timing.

Financial planners can use computer projections to test two alternate scenarios. One is to start RRSP contributions when you are still young with big mortgage debt. The other is to start after you are debt free, making use of enhanced cash flow from having no mortgage payments. The winning scenario basically depends on how the expected RRSP growth rate compares to mortgage interest rates.

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