One of the big questions for Canadians who are heading into retirement and are carrying mortgage or credit-line debt is whether to pay it off right away, or do it gradually over time.
Seniors were once a group with low or no debts, but no longer. Now they’re the demographic with the fastest-rising levels of borrowing. Here’s a scary statistic: A report from bankruptcy trustee Hoyes, Michalos & Associates this spring found that three in 10 bankruptcies are coming from the over 50s. Of the 6,000 bankruptcy cases the firm looked at, the over 60s were in the worst shape.
Conventional wisdom has it that you shouldn’t owe anybody anything when you retire because your ability to pay it off is diminished. Your income is fixed and if your pensions are not inflation-indexed, the real amount you’re living on is falling over time. Diverting cash to pay what you borrowed long ago isn’t wise.
But as with most things to do with personal finance, one size doesn’t fit all. In some cases, it could make sense to pay the debt off slowly.
Here’s an example:
A reader named Stuart and his wife retired three years ago and between them have good pension income of $105,000 a year. They also have $100,000 in RRSPs. They are mortgage-free, but owe $17,000 on a line of credit.
They’ve been making good progress chipping away at the loan. Three years ago, they owed $40,000. They pay it down at $500 a month.
“That leads to my question,” Stuart said. “Is it better for us to continue clearing off the debt the way we are, or would it be more advantageous for us to use our RRSP?”
The interest rate on Stuart’s line of credit is under 3 per cent. On the other hand, cashing in the RRSP means paying tax — the flipside of that of those refunds over the years. The amount withheld depends on how large the withdrawal is.
If the withdrawal is $5,000 or less, you’ll be subject to a withholding tax of 10 per cent. The tax is 20 per cent if you take out more than $5,000 and less than or equal to $15,000. Above $15,000, the tax is 30 per cent.
You may pay more tax when you file your return or get some back, depending on your bracket.
“If it makes sense to use our RRSP, is there an optimal amount to remove?” Stuart asked. “And, should the funds come from the person with the higher pension? Or the lower pension? Or some sort of split?”
I asked Dan Hallett, a financial planner and principal with Oakville’s Highview Financial Group, for his opinion. “It makes more sense to keep servicing the loan,” he said.
Since the interest rate on the credit line is less than 3 per cent and the payment is $500 a month, the loan will be paid off in less than three years, he says. The interest expense will be about $760.
The RRSP route is more expensive. In order to get $17,000 in hand, Stuart would need to withdraw $25,000, because almost $8,000 would be withheld in taxes.
Hallett says that between the taxes and missing out on the potential growth of the $25,000 in his RRSP, paying $760 of interest is a better way to go.
“So keep paying the loan,” he says. “If the goal is to wipe out the loan as quickly as possible, make extra payments. In less than three years, it will be gone — with more than 95 per cent of the payments going directly against the principal.”
Hallett says that even if interest rates rise by a point each year, the gradual repayment is better.
“The outcome isn’t materially different,” he says. “This is mainly because so much of each payment pays down principal.”