|Contributed by: martingale |
Many of you are interested in using your RRSP savings to finance the purchase of your home, either through the Home Buyer's Plan, or by holding the mortgage of your home in your RRSP. This may be a bad idea from an asset allocation standpoint. In this article we'll consider the risks associated with owning a home, and how best to mitigate them.
Lack of Diversification
A big problem with a home as an investment is that it is too much money invested in one asset. Your investments should be diversified as much as possible--that's why you buy indexed mutual funds: if you own a little bit of every stock on the market then you won't much care what happens to individual companies, so long as overall the market goes up. It's the same story with real-estate: When you invest in real-estate you really should buy a REIT, so that you own a little bit of many different properties, rather than investing directly in just one or two buildings.
However, when you buy a home you have invested a very, very large fraction of your net worth into a single asset: A single home, in a single neighbourhood, in a single city. Random unforseen events in the area of your home could have a devestating effect on your net worth (or, more happily, lift you into a life of luxury). This is generally a bad thing: you aren't diversified enough.
Some Good News
Owning a home is not all bad, though. I do want to note here the advantages so you don't think I'm simply negative on the idea: A home can be a reasonable hedge against inflation. If we ever experience double digit inflation in Canada again your stocks and bonds will crash, while your home will tend to maintain its value. There are also substantial tax breaks on home ownership--if you do turn a profit on your primary residence you won't have to pay any capital gains tax. These advantages make up a bit for the fact that a home is a fundamentally poor investment from an asset allocation point of view.
Implications for your RRSP
Should you divert money you have saved in your RRSP to your mortgage? In general: No. You want to have other assets besides your home, and the rate of return on investing in your mortgage is probably less than what you could have earned in your RRSP.
Diverting your RRSP savings to your mortgage would reduce your overall diversification even further, making a bad thing worse. The value of your home is somewhat independent of the stock market: There is some probability that if your home drops in value, that by random chance, your stocks and bonds will do well that year. In a pinch, if the bank demanded an additional down payment you would be able to liquidate your other investments to come up with the extra funds. This is why diversification is a good thing, and it's the main reason why you should prefer not to divert RRSP money to your home.
Second, your mortgage does not have as attractive a return as the investments available to you inside your RRSP. A variable rate mortgage will cost you less than the prime interest rate, while even short-term government bonds return more than the prime rate. Investments that are equal in risk to owning a home (more risky than government bonds) have much higher returns. Why would you want to trade a bond return of 5.5% or a 10% return on the stock market for a "return" of 4% on your mortgage payments?
Note that the answer may be different for non-RRSP funds: There is no tax on paying down your mortgage, whereas you would have to pay tax on the interest earned on a bond held outside an RRSP. The taxation of your bond return likely pushes the bond yield below your mortage interest rate. On the other hand, any money you pay against your mortgage compounds tax free--there is never any tax on reducing debt. As a result, once you have maxed out your RRSP contributions you should consider using all additional funds to pay down your mortgage.
The Exception to the Rule
There is one exception to the rule that you should not invest RRSP money in your home, and that is if you absolutely need the RRSP money in order to finance the purchase of your home. If you can't come up with a 25% downpayment you'll get dinged with expensive penalties such as a higher interest rate and "mortgage insurance". Coming up with 25% can significantly reduce your costs, and it may be that your only way to do this is to tap your RRSP funds.
First off, I would advise you not to do this anyway: Find somewhere cheap to rent, and save your pennies until you can afford to make the downpayment with non-RRSP funds. On the other hand, you have to enjoy your life. You may consider it an important pleasure to own your own home, and to live in it. If you are absolutely determined to buy a home, and you cannot make a 25% downpayment without your RRSP money, then go for it--but not because it is a good investment, but rather, because you have decided to spend your savings on something you enjoy.
See Also: Your RRSP and Your Mortgage: The Home Buyer's Plan