Straight talk on RRSP loans

Last year we saw the government cut rates and now we have some of the lowest rates in many years. This year, the prime lending rate is 3.75% and most financial institutions will lend you money at prime for your RRSP contribution.

Does borrowing for your RRSP make sense?

If you borrow $10,000 to buy your RRSP, it will cost you a little over $200 in interest over the course of a year. Even though you cannot deduct the interest on loans for RRSP contributions, this is a relatively small price to pay considering the tax benefit you will get. Depending on your marginal tax rate, you are likely to get somewhere between $2300 to $4900 in tax savings. Add in the tax-deferred growth inside the RRSP and you’ve got a pretty solid investment.

Use common sense

Regardless of how good the RRSP loan might sound, you still have to pay back the loan. In this same example, you have to pay $850 per month. So common sense is that you should borrow within your means. Remember, most RRSP loans are floating rates so if prime goes up, so will the interest on your loan and so will the interest cost over the term of the loan.

One of the ways to reduce you monthly payment is to spread the term of the loan for longer than 1 year. The longer the term, usually the higher the rate. On that same $10,000 loan, you might have a rate of 4.75% over 2 years instead of one. Despite the higher interest rate, your payments will be much lower ($437 per month). Remember, the longer you spread the term of the loan, the more interest you will wind up paying ($497 of interest instead of $200). Try your best to pay off you RRSP loan as quick as possible.

Use your tax refund to pay down your loan

Rather than take your tax refund and spend it, consider paying down the loan so the loan gets paid off much faster and you will pay less interest. Continuing on this same example, if you took a $4000 refund and put it against the $10,000 loan, you would pay off the loan in 15 months instead of 24 and pay only $229 of interest.

Some institutions will set up the RRSP loan with a deferred payment period. For example, Manulife Bank has a 90-day deferment period where you do not have to make any payments for 90 days. This program gives you the time to get your tax refund and pay off the loan before you have to make any payments.

A great time to borrow

Interest rates may not stay down this low for a long time. We are sitting at historically low interest rates to try to foster the economy and markets. Should either or both of these pick up in the up coming year, you may see the pressure on low interest rates ease.

Take advantage of these low interest rates

There is a couple of other interesting strategies for investors to take advantage of these low interest rates:

  1. RRSP gross up. Let’s say you have $5,000 to contribute to an RRSP. Let’s further assume you are in a 40% marginal tax rate and your RRSP limit is higher than just $5,000. What you might want to do is borrow another $4,000 to contribute to the RRSP for a total contribution of $9,000. With this $9,000 you are likely to get a $3600 tax refund which in turn can be used to pay down the $4,000 RRSP loan. This strategy gets you $4,000 more into the RRSP at a very minimal cost.
  2. RRSP catch up. Many Canadians have considerable “unused” RRSP contribution room. If you do not maximize your RRSP, your remaining allowable limit gets carried forward to a future year. Many RRSP institutions will allow you to borrow to catch up and maximize your RRSP limit. This is especially attractive if you have an unusually high-income year as a result of bonuses or dividends for example.

Try to get ahead

While I’ve offered some compelling reasons why an RRSP loan makes sense, it is still better to contribute to RRSPs without a loan. Do your best to get ahead and contribute monthly rather than trying to come up with a lump sum at the end of the year.

While interest rates are low, debt should always be used with some caution. Don’t get too carried away and make sure you shop around for RRSP loans.

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