My Canadian is showing again, AND I REFUSE TO COVER IT UP. If you’re an American, this post may not apply to you. I apologize for nothing. Move to Canada. Sure, it’s colder here, but the ladies are hotter and the health care is FREE BABY!
So, let’s assume you were kind of a slacker this year and didn’t bother saving much of anything to use to contribute to your RRSP. You spent the money on strippers and cocaine, and then wasted the rest. Because you’ve heard all about how you should be saving for retirement, you want to contribute, but have the small problem of not having any cash. What’s a poor fella to do? How about an RRSP loan?
An RRSP loan is available at your local financial institution at prime +1-2%. (meaning you’d pay 4-5% for one today, depending on your credit worthiness) They can be set up as either a line of credit or a straightforward loan, and I’m sure the bank issuing it will let you take a few years to pay it off if you so choose.
At first glance, they seem like a bad idea. Why not just set aside a few hundred bucks a month to contribute to your RRSP? Better yet, if your employer offers any sort of RRSP match, you should be taking advantage of that right now and than thank them profusely for the free money. And yes, I agree. Ideally you should be contributing every month, or even in one lump sum payment on February 28th because you procrastinated all year. (This may or may not have happened to me)
But what about if you’re just starting on your financial journey?
Let’s assume somebody is in the 40% tax bracket, just for easy figuring. They take out a $5000 RRSP loan at 4%, doing it in February, since they know their income tax refund will be coming back in March. To keep things simple, let’s assume our imaginary person paid exactly enough tax, meaning their entire refund will be because of their RRSP contribution.
If the entire tax refund is put towards the RRSP loan, that means the amount owing is $3000 after just a month. $300 per month takes care of the rest of the loan in 11 months. At a 4% interest rate, a paltry $46 is paid in interest. You paid $46 to access $5000. That is a ridiculously low cost to pay.
There’s a couple caveats. If you don’t use that tax refund to pay down the loan, you obviously shouldn’t bother. And, secondly, if you have to repeat this process every single year, you probably need to work on your savings skills. This strategy is designed for someone just starting out, someone with little debt so they can afford the payments.
Most of the time, someone using this strategy will be getting a larger tax refund than just the one created by contributing to the RRSP. If our imaginary person from above was getting an additional $1000 in a tax refund before contributing to the RRSP, they could pay off that loan in just 7 months, meaning they’d have 5 more months to put that money towards next year’s RRSP contribution.
Naysayers will point out the flaws in recommending someone go into debt. People are morons they’ll argue, why would you recommend they go into debt? Well, I believe that debt used to buy assets is generally good debt, assuming people are smart and pay it off in a reasonable amount of time. Many people abuse debt and it gets them into trouble. There are all sorts of other people who use debt to their advantage. You’d have to be a special kind of moron to borrow to invest in an RRSP if you have credit card debt.
This strategy isn’t for the faint of heart either. By borrowing to contribute, you’re using leverage, which automatically makes any investment more risky. Imagine borrowing $5000 and investing it in the stock market, only to have the market fall 10%. Your $5000 has dropped in value to $4500, and you might not have paid a dime back. If that type of situation makes you all queasy, you probably shouldn’t borrow to invest in general.
And, of course, the higher interest rates get, the less appealing this strategy becomes. If you double the rate, you double the cost of borrowing. (That may have been the most obvious sentence I’ve ever written) At what interest rate does the cost of borrowing become too much?
I actually think borrowing to invest in an RRSP isn’t such a bad idea, providing the borrower pays the damn thing off quickly and doesn’t blow their tax refund on video games and Fanta. Now you can disagree with me in the comments.