The Portfolio Doctor

By David Cruise and Alison Griffiths
--------------------------------------------------------------------------------------------------

The Patient: Carmen H., 29

Situation: Single, no kids, employed full-time

Income: $54,000

Debts: none

Investments: RRSP - $24,000 Non-registered - $12,000 high interest savings account

Concern: "I am looking to buy my first home in the very near future. Is it better for me to keep saving another $18,000 to add to my $12,000 and use $20,000 of my RRSPs to put $50,000 down payment. Or should I not touch my RRSPs and pay the penalty of not having 25 per cent for my down payment?"

So far, Carmen gets a gold star for forward thinking. She's young, has no debts, $36,000 in savings and she's adding to it at the rate of $2000 a month. Wow!

After living in New Zealand for a year and then traveling for another five months, she re-settled in Toronto, taking advantage of living at home to save for her first home. She's aiming to buy in the $200,000 to $225,000 range.

The Home Buyer's Plan (HBP), which allows first time buyers to use up to $20,000 of their RRSP for a down payment, is wonderful for young people who are eager to get into the market, yet have not or cannot save enough for a down payment. (For more information go to www.cra-arc.gc.ca. Click on RRSP then on Home Buyer's Plan.)

Because Carmen has unregistered savings, an RRSP, no debts and can live cheaply; she has a number of options. We based our analysis on a condo costing $210,000.

If Carmen withdraws $20,000 under the HBP, the maximum she can take out of her RRSP without triggering taxes, she will have to pay it back within 15 years, which amounts to $1,333 a year or $111 a month. She can return the funds more quickly but if she doesn't pay them back within the 15 years, the amount outstanding will be treated as taxable income.

The size of Carmen's down payment will determine how much her mortgage insurance premium will be. For example, with a 10 per cent down payment of $21,000, the insurance costs would be 2 per cent or $3780 on a $189,000 mortgage. (For more information, go to www.cmhc.ca and search for Mortgage Loan Insurance.)

Looking at two different scenarios helps bring the issues facing Carmen into focus.

Option # 1: Carmen leaves her RRSPs alone and puts $21,000 down on her home ($12,000 from current savings plus $9,000 further savings). The down payment is less than 25 per cent so she will have to pay $3,780 in mortgage loan insurance. Her mortgage payments, at 6 per cent, will be about $1209 a month and, assuming she amortizes over 25 years, her home will cost her $362,700, including interest over that period.

Option #2: Carmen beefs up her savings to $30,000 and draws $20,000 from her RRSP for a $50,000 down payment which means she will pay no insurance fees. Her mortgage payments drop to $1023 a month, $186 less than option #1. Her home will cost $307,107 after 25 years with $147,107 in interest paid versus $173,771 for option #1.

With option number #2 Carmen saves $26,664 in interest over the 25 years, plus $3780 in insurance premiums (we're assuming she would have paid this up front rather than added it to the mortgage.) If she invested that $3780 for 25 years it would grow to almost $26,000 at an 8 per cent average annual compounded return.

On the face of it, option # 2 is the way to go, but let's see what happens if we play out option # 1 to the end.

Option # 2 does feature lower mortgage payments, but it is a little deceptive because, for the first 15 years, Carmen would be paying $111 back monthly to her RRSP, leaving a net difference of only $75.

If Carmen leaves the $20,000 in her RRSP to grow, at the rate of 8 per cent on an average annual compounded basis, it will amount to $137,000 in 25 years time. So then option # 1 is the way to go, right? Not so fast! What about the difference in mortgage payments?

Let's say Carmen chooses option #2 and religiously invests the $75 a month difference between the mortgage payments for the 15 years she's repaying the money borrowed from her RRSP. And let's assume she continues to save that $75 a month plus $111 monthly (the amount she was returning to her RRSP) for the remaining 10 years of her mortgage. After 25 years Carmen would have $91,632, assuming the same 8 per cent rate of return.

On top of that she'd have the projected $26,000 from investing the money that would otherwise have been spent on the insurance premium. In addition, the money she pays back to her RRSP is going to be growing. And that amounts to $85,256 over 25 years, at 8 per cent. It all adds up to $202,888 in invested savings for option # 2 considerably better than the $137,000 figure as a result of choosing option #1.

The figures don't take into account inflation and, in the case of option #2, the investments held outside the RRSP could be subject to income tax on any interest, dividends or capital gains.

Undoubtedly, Carmen would shelter some, if not all it in her RRSP. Of course, interest rates change, so these conclusions about mortgage costs will also change.

If Carmen can delay her gratification until she saves up $30,000 to add to the $20,000 from her RRSP and is able to save the difference in mortgage payments, option # 2 seems like the best choice.

If Carmen were to choose option # 1, she should take into account the general rule of thumb which suggests homebuyers keep the carrying costs of a mortgage (principal, interest, taxes and condo fees) to a maximum of 32 per cent of gross income. In Carmen's case, that would amount to $1440 a month. But with $21,000 down her mortgage alone will be $1209. On top of that she will have condo fees, mortgage insurance and taxes which would certainly push her over that ideal percentage.

In this light, it makes sense for Carmen to save up for a larger down payment to avoid becoming house poor and strapped for cash. And cash is important. New home purchasers almost always neglect to budget enough for additional expenses. Even after scrounging cast offs from friends, relatives and family, there are always things to be bought.

There are lots of numbers here, but don't let the calculations make you dizzy. The point is that in order to compare options it is critical that you carry your analysis right the way through to the end.

It is also important to take into account your own spending habits and your savings personality. There's no point in choosing a path which assumes you will save a certain amount if money burns a hole in your pocket.