Borrowing for RRSPs: Maybe not such a good idea

This year’s Feb. 29 deadline for RRSP contributions is bearing down, and the needle in your savings account is stuck on empty. Does it make sense to get a loan to rev up your retirement savings? Or would it be wiser to just take a pass on this year’s contribution?

It depends.

“Answering this question involves taking stock of where am I today and where do I need to be down the road and how am I going to get from A to B in the most reasonable manner,” said Jillian Bryan, vice-president and portfolio manager at TD Waterhouse in Vancouver.

Taking out a loan to make a contribution to your Registered Retirement Savings Plan may be a way to help you get there.

On the other hand, it may be more debt at a time when you may be better off paying down other loans or credit card balances.

“RRSP loans are like any other financial product. For the right person, in the right circumstances, it can be a great solution,” said Mark Coutts, certified financial planner with Sun Life.

There are two occasions where it makes sense, he said.

The first is where someone is significantly behind in his or her retirement planning and needs to kick start their savings.

The second is a loan for someone who is looking to top up their annual contribution.

“For someone who wants to get a little extra money in for the 2011 tax year, but doesn’t have the extra cash on hand, it can be a good short-term solution,” Coutts said.

“Borrowing to invest isn’t always such a wise strategy, but an exception to that is the RRSP loan, and that’s because of the taxation rules.”

Here’s an example:

Say a 40-year-old, who has 25 years until retirement, takes out a $5,000 RRSP loan, and plans to pay it back within one year.

The interest rate on that loan would probably be about 4 per cent. The total interest payable would be about $109. The monthly payment would be $425.75 for 12 months.

If this person makes $60,000 a year, their marginal tax rate would be 31 per cent. In this case, the $5,000 RRSP contribution would be deducted from the person’s income, and that would result in a refund of about $1,550.

Most RRSP providers will extend the loan in February and allow you to defer the first payment for three to six months. That gives you plenty of time to file your tax return in April, get the refund and use it to pay down your loan.

“To maximize the benefit of an RRSP loan, take the refund and pay down the loan balance immediately,” Coutts said.

In this example, that leaves a balance of less than $3,500 on the loan.

Paying it down immediately, lowers the total interest cost to below $75.

If the payments stay at $425.75 per month, it will take just nine months to pay off the loan, instead of one year.

Meanwhile, the $5,000 investment, earning an average annual return of 6 per cent, would grow to $21,000 over the next 25 years.

“It shows the power of compounding, but also of taking advantage of the tax act and today’s low interest rates,” Coutts said.

If you’re considering a loan, ask yourself two questions, says Coutts: Do you really need a loan? and: Can you afford it?

A financial advisor can help you answer the first question by developing a financial plan and retirement forecast for you.

Aim to pay back the loan within one year, Bryan said. “If you don’t pay it off within the year, you risk making it a permanent part of your debt load. Debt really is a double-edged sword. Often people are motivated by instant gratification and what they’re acquiring and they forget that they have to pay for it.”

Coutts suggests thinking carefully about large RRSP loans that are paid back over five years. It may be tempting, but keep in mind that you will also be locked-into a debt repayment plan for the next five years — and that, in turn, may make it more difficult for you to tuck away any savings.

If a loan is in the cards, don’t leave it until the last minute.

“An RRSP loan, like any other loan, requires approval, which can take a few days. The borrower is not guaranteed the funds until their loan application is approved,” Coutts said.

Ideally, the rate of return on the investments in your RRSP should be greater than the interest rate you will pay on your loan.

Borrowing rates are low these days, but, then again, stock markets are gyrating and interest rates on GICs and other fixed income products, are next to nothing.

Gail Bebee, personal finance speaker and author of No Hype — the Straight Goods on Investing your Money, isn’t a big fan of borrowing, and that includes RRSP loans.

Her two cents: “If you have credit card balances, pay off the credit card balance!” Bebee said. “You’ll never make that kind of return on your RRSP.”