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An informal, stream-of-consciousness reflection on business ideas, events and issues in modern business, modern life and with some specifics to the web-software industry by Paul Tomori, Internet Entrepreneur

Canada's New Tax Free Savings Account: Opportunity Awaits
A Gift From The Government

By Paul Tomori
Monday, January 26, 2009 at 10:04:03 (EST)

"Disclaimer: I am not a mortgage specialist or advisor. As a businessman, I just have an interest in such things. Please do your own calculations for your particular situation to determine what is best for you."

Important Note: This blog entry was updated on February 23, 2010 in order to correct some calculation errors introduced by the original online mortgage calculator we used (Thank you, Kelly D. for pointing this out). For the updated calculations, we used the TD Canada Trust online mortgage calculator and the Canadian Government TFSA compound interest calculator (links indicated below). We have increased the presumed compound interest rate from 4% to 5%, not so that our TFSA scenario would still win, but because we wanted to bring the two scenarios closer to parity. Why is this important? Well, all things being equal, one can then adjust the variables in either scenario, one setting at a time, to see which scenario would work best in your particular situation. When calculating the compound interest in the TFSA, we see wildly variant numbers depending on how frequently the contributions are made and whether the investment starts at the beginning of the year or at another time or spread out as monthly payments. For the purposes of the illustrations below, we presumed 10 yearly payments of $5,000 compounding yearly.

Generally, a gift is something one "receives". Let's call that a "Class E" (i.e. classy!) gift. In the case of the TFSA from the government of Canada, the gift is that less is taken from you. Let's call this a "Class F" gift. Either way, you win!

The various newspaper ads have caught my eye lately about Canada's new Tax-Free-Savings-Account (TFSA). I have checked into it and definitely, in my humble opinion, it qualifies as a gift, albeit Class F. At first, I thought, "yay, I get to store cash in a savings account and get what... maybe 2% interest (if I am lucky)", but on further investigation, I have learned that the moniker "savings account" is very bad. In fact, the account is an investment account. You can buy stocks, bonds, GIC's and almost anything else that you would also purchase within your RRSP. The big difference between the TFSA and RRSP is that you will never get taxed on any interest/dividends/capital gains that you earn through compounding within your TFSA, while in the RRSP, you pay tax when you withdraw.

The drawback with the TFSA is that you only get to invest $5,000 / year. I told one of my friends about it and like me, he scoffed at the notion of putting any money into a "savings" account. When I showed that the account is much more versatile, he said "it is smarter to pay down the mortgage instead". That got me thinking. Is it better to pay down a mortgage faster with yearly top-ups of $5,000 or is it better to invest that $5,000 in the TFSA? Here's what I found:

Comparing TFSA vs Mortgage Top-Ups

The following compares the benefits of investing $5,000 per year in the new Tax-Free-Savings-Account (TFSA) versus applying that same $5,000 to an existing "standard" mortgage on a primary residence. Both investments are comparable, because both result in no capital gains payable on net growth.


Mortgage Calculator:

Compound Interest Calculator:

Mortgage Variables

These were my presumptions in both scenarios in order to compare apples to apples:

  1. Standard Mortgage of $300,000
  2. 20 Year Amortization
  3. Paid Weekly at $456.65
  4. Mortgage interest rate: 5.1%
  5. For the sake of simplicity, let's presume a zero money down mortgage in both scenarios (it changes nothing in the comparison)

Scenario 1 (Applying $5,000 annually to a TFSA):

After 10 years of paying the mortgage with no lump sum top-ups:

$237,914.65 total has been paid to the bank
$124,948.48 interest has been paid
$112,966.17 principal has been paid
This leaves a net loan balance of: $187,033.83 on the original $300,000 loan

Add TFSA Investment: $5,000 annually for 10 years at 5% compounding = $64,443

Scenario 1 Conclusion: After 10 years, let's presume that the property value is now $400,000, a gain of $100,000, so net worth is: $100,000 + $112,966.17 + $64,443 TFSA = $277,409.17 net worth

Scenario 2 (Applying $5,000 annually to Mortgage on Primary Res.):

After 10 years of paying the mortgage, but with $5,000 lump sum top-ups yearly:

$287,914.65 total has been paid to the bank
$111,098.02 interest has been paid
$176,816.63 principal has been paid
This leaves a net loan balance of: $123,183.37 on the original $300,000 loan

Add TFSA Investment: $0.00

Scenario 2 Conclusion: After 10 years, let's presume the property value is now $400,000, a gain of $100,000, so net worth is: $100,000 + $176,816.63 + $0.00 TFSA = $276,816.63 net worth


Scenario 1 narrowly beats Scenario 2 by just $592.54

Any investment of liquid capital in the TFSA bears some risk. This can be mitigated by selecting bonds over stocks, in particular "investment-grade" bonds. Yet, there is also risk that the home value could go down as we have seen in the last year in many parts of North America, though the risk historically is low and for both scenarios above, we assume a similar ending property value. Generally, property value declines are mitigated by time anyway, so let's not let that issue cloud things.

In scenario 1, the 5% interest within the TFSA is presumed to be a relatively safe investment. Other "mostly safe" investments in the TFSA, such as a corporate bond in a brand-name Canadian bank could do MUCH better at least for year one of the investment (example: BMO's 10.1% coupon rate on their December 2008 bond issue available for purchase through ETRADE on an 8.7% yield. Note: this bond is no longer available at such an attractive as at February 22, 2010). Presuming that such attractive bond yields go down as the economy improves, we could still count on a 5% or 6% yield rate for subsequent $5,000 annual top-ups in the TFSA while still investing in investment-grade bonds (i.e. A through AAA). Such would make the net worth or future wealth in scenario 1 much more dramatically higher. For example, at an average of 7% interest in scenario 1, the resulting TFSA value would be $71,459 whereby scenario 1 would then beat scenario 2 by a significant amount: $7,016.00. Imagine if one could do 8 or 9% in their TFSA. Over 10 years, investing in a good stock index, getting an average of 8% or 9% can be historically supported.

The presumption that a mortage rate of 5.1% can be enjoyed for the whole mortgage term is perhaps a long-shot. As mortgage rates rise, the allure of applying the $5,000 amounts to a mortgage instead of the TFSA will start to grow considerably. At a 10% mortgage rate, it is about $25,000 smarter for your net worth over 10 years to NOT put your $5,000 into a TFSA, but to put the $5,000 toward your mortgage instead. It all comes down to timing. Under current market conditions, it is more sensible to use the TFSA, but that can change and probably will... and when it does, your investment strategy should change too.

For example, while the idea of having a larger mortgage balance when interest rates have perhaps risen in coming years may not be desirable, at that time, the significant TFSA balance can, without any penalty, be applied immediately to the mortgage balance in one lump sum payment resulting in a lower overall mortgage loan balance for scenario 1 compared to scenario 2. So, even if mortgage rates rise sharply, the TFSA can win in the short-term as long as one remains prudent and aware of market conditions. Hint: lock in a low mortgage rate for 5 or 7 years if you can folks!

Another consideration... After 10 years, the TFSA could be a highly liquid investment that could be used for other priorities whereas all the extra mortgage contributions in scenario 2 are now locked inside the walls of the house and cannot be easily extracted if needed without a 2nd. mortgage.

Finally, if one DOES apply their TFSA balance after 10 years to bring down their overall mortgage loan balance, the TFSA rules permit the individual to still be permitted to "replace" $50,000 of the withdrawn TFSA funds with a new investment ($5,000 per year for 10 years). This means, in effect that in addition to increasing one's net worth in the near-future, in the long-term, the TFSA could become a very valuable vehicle for a fresh investment to be made of $50,000 that will continue to generate tax-free gains. Hopefully, in 10 years you will have the problem of wondering what to do with $50,000 in free cash!

Final Conclusion:

This is just one situation above and your particular circumstances and mortgage details could be VERY different. Use the calculator links provided above to determine what is best for you.

Even if the winning numbers don't compel you to invest in the TFSA... (perhaps you are old school and prefer to own your house outright as soon as possible), then consider the following:

Either way, even if you don't buy into the TFSA concept, do yourself a future favour and register for the account and just put $25 in it. Getting started will allow you to accumulate $5,000 per year in contribution room which could REALLY be handy in 10 years. It will cost you $25 now to have that flexibility in 10 years, whereas if you start in 10 years, you'll only have $5,000 of contribution room. Personally, I think the TFSA rocks. Multiply the benefits times 2 if you have a spouse. It seems like a gift to me. Invest wisely.

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