Friday, 4 January 2008

RRSP Loans: What to Do and Not to Do

Suppose you have unused RRSP contribution room but it's the end of February and you don't have the cash on hand to make a contribution before the deadline. Should you take out a loan or should you just start contributing monthly to the RRSP? There doesn't seem to be much substantiated / well analyzed advice out there on whether taking out a loan to contribute a lump sum to an RRSP makes sense so here goes. (This one is for you Nicole since you brought up the question.)

Being a non-believer in loans generally (the only loan I've ever had in my life is a mortgage), I have been greatly surprised to find that taking a loan to contribute to an RRSP is a smart move if it is done right. And it is useless if done wrong. The do's and the don'ts are very simple, easy to follow principles.

Do This (in order of priority):

  1. by all means take out a loan BUT use all of your tax refund for your RRSP as soon as you receive it by either reducing the loan balance or by reinvesting it in the RRSP (it doesn't matter much which you choose as I explain below).
  2. repay the loan as soon as possible - the shorter the repayment period the better as you will increase your net savings faster; make sure you can handle the monthly payments, including some leeway in your budget for the inevitable major car repair/vet bills/dental work at the worst possible moment;
  3. a multi- year loan to catch up a backlog of past accumulated contribution room is beneficial as long as you follow rule #1 above every year
  4. reduce the loan payment amount, using the reduction to continue to contribute to your RRSP if you still have contribution room and if you have no contribution room left, start investing the payment difference in a non-registered account, or
  5. keep paying the same amount so that your loan is paid off as soon as possible
Do NOT Do This:
  1. spend the tax refund; if you do, you would much better off taking the equivalent amount of the monthly loan payment, contributing it to the RRSP each month, then spending the refund you get a year later; spending the refund blows the whole loan scenario out of the water - you are wasting your money.
The Scenarios I Looked At:
  1. Take Out a Loan, Make a Lump Sum Contribution to the RRSP, Reinvest the Refund in the RRSP and Do Not Reduce the Loan Principal
  2. Take Out a Loan, Make a Lump Sum Contribution to the RRSP, Reduce the Loan Principal and the Payments with the Refund, Add the Monthly Difference in the Payment to the RRSP
  3. Instead of a Loan and Lump Sum, Invest in the RRSP the Same Monthly Contribution as the Loan Payment Would be and Reinvest Tax Refunds in the RRSP as Received
With all the scenarios, I used a spreadsheet to calculate. I plugged in different loan rates and investment return rates, loan repayment durations from one to five years and yes/no refund reinvestment decisions. In all cases, the loan was considered to be taken out just before the February deadline so that the contribution could be counted for the previous tax year and so that the tax refund would be received 3 months later. My criteria for success was net savings wealth, as measured by cumulative RRSP value at the end of each loan repayment.

Caveats, Assumptions and Things That Don't Matter
  • if you do happen to have the cash on hand but wonder whether it is better to take out a loan anyway, that will only pay off if the rate of return on the RRSP exceeds the loan interest rate; Moshe Milevsky explained this in Chapter 7 "Borrowing to Invest" of his book Money Logic
  • the tax bracket you are in (as long as you pay some taxes ... but then you wouldn't have contribution room if you didn't, would you?) does not affect whether you should take a loan, it only increases the benefit if you are in a higher bracket because you get a bigger tax refund
  • surprisingly, the "which is better" answer is quite insensitive to the rate of return on the RRSP investments and the loan interest rate - for differences of 1 or 2% between loan rate and investment return rate, the end result of the two loan scenarios was quite close; in cases where the loan rate exceeded the investment return, scenario 2 was better, and where the return was higher than the loan rate, it was the other way round. It takes a difference of 4-5% to make scenario 1 or 2 significantly better than the other. The reason for this is a key concept for all situations - the tax refund is the critical benefit and main differentiator - the sooner you receive it and invest it, the better off you are. In addition, the loan principal amount on which you pay interest begins to decline from month 1 onwards while the RRSP goes up constantly with any positive return and is boosted significantly by the refund, so that the net interest gained is higher from the RRSP than that paid on the loan - e.g. for a $1000 twelve month loan at 8% the balance in month 6 is $509.97, the interest is $3.95 while the RRSP with annual return of only 4% has gone up to a balance $1333.28 (assuming reinvestment of the $310 refund for an Ontario taxpayer with taxable income in the $37-62k band and a marginal tax rate of 31%) gains $4.43 in return
  • that also the main reason that scenario 3, where you simply invest on a monthly basis and take no loan, comes out behind the loan options except in extreme cases where the loan rate is very high and the investment return is more or less zero; when you invest as you go, you are always playing catch up, effectively one year behind in receiving those tax refunds and always getting a lower return on a lower RRSP balance
  • in my calculations, I assumed the refunds from the reinvested refunds would also be reinvested; they get smaller and smaller but they do make a difference; the more you have invested and the sooner it is invested, the greater the effect of compounding
  • if you have taken out a multi-year loan and still haven't paid it off but have generated more RRSP room in the past year but still don't have the cash, does it make sense to take out a new loan for a new lump sum contribution? my answer is yes, as long as you can handle, with some safety margin, the combined payments; the same logic applies and it still makes sense for the same reasons.
Othe Factors to Consider:
  • a loan can be much more forceful in ensuring that you actually make the savings because it's not just your decision to reimburse or not, you are compelled to do it; a big problem in saving is actually getting round to do it and sticking to it
  • a loan is riskier in case of unforeseen urgent expenses; it is easy to interrupt RRSP contributions; you need to have confidence in being able to pay the loan
  • with scenario 2 and a small loan, the monthly reinvestment amounts may be hard to reinvest at a high rate within the RRSP; having the contribution sitting in cash will ensure that your rate of return is below that of the loan rate; maybe using a mutual fund is the way to invest that monthly amount in the RRSP
  • many/most RRSP loan lenders will allow you to defer the first payment for a few months to allow your refund to come in; that may allow you to reduce the loan principal and payment to an affordable level and thus allow you to make a larger catch-up contribution

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