Tax Credit for Student Loans

In the process of helping some students in my family with their finances, I came across the fact that certain types of student loans benefit from a tax break on the loan interest.

The benefit is in the form of a tax credit, meaning that it is a straight reduction of tax. Other key features and conditions (see CRA's page on tax matters for students) include:

• the credit is non-refundable, meaning that if the student has no tax to pay before applying the credit, the credit is not refunded and the credit goes to waste; in other words, apply for the credit only when there is tax to pay.
• the credit does not have to be used in the same year as the interest on the loan was paid, it can be carried forward and used up to five years later
• the credit is not transferable to another person, like a parent or spouse, only the student him or herself can use it, even if someone else actually paid the interest
  
• the credit is calculated at the lowest Federal tax rate (currently 15%) plus the lowest Provincial tax rate (e.g. Ontario is 6.05% so $100 interest would get the student $21.05 in tax credit/reduction); Québec as usual does its own thing and gives 20% flat credit; the credit does not change or increase if the student is in a higher tax bracket and since it is a tax credit not a deduction that reduces taxable income it cannot help to bring someone down into a lower tax bracket; in other words, there is no advantage in waiting - as soon as the student starts earning enough income to have tax to pay, he/she should claim the credit.
• the credit only applies to loans issued under the Canada Student Loans Act, the Canada Student Financial Assistance Act, or similar provincial or territorial government laws for post-secondary education (to check if a loan qualifies, ask the national student loans service center or see the list of provincial student loan contacts here on Canlearn.ca); loans from banks or private lenders don't qualify, nor does a qualifying loan if it has been combined with or refinanced as a private loan
• the claim is made on line 319 of Schedule 1 Federal Tax of the T1 and on the corresponding line in the provincial tax form - e.g. line 5852 on ON428 Ontario Tax
  

RRSP Loans: and Another Thing - Timing is Crucial

My last post concluded that it is worthwhile to borrow to make a lump sum RRSP contribution just before the deadline at the end of February if the tax refund is used either to reduce the loan principal or to contribute back into the RRSP.

What happens if you have barely missed the deadline and are sitting there on March 1st wondering if it still makes sense? The answer is most likely NO. You are probably better off to start making monthly contributions (I'd suggest you use automatic deductions from your bank account so you actually do it), for instance by putting in the same monthly amount as you would have done to pay off the loan.

Why is this so? The reason is that the tax refund won't be coming back to you till the following year instead of within three months or so if you manage to meet the deadline. The absence of that immediate extra boost to your savings destroys the value of the loan in most reasonable scenarios. The only scenario in which the loan still comes out ahead of the regular monthly contributions is when the investment return rate exceeds the loan borrowing rate by 2% or more. Think of the probabilities. On the one hand the loan rate is a sure thing, it won't be lower by chance; on the other hand, the investment return is very uncertain if it is in equities, which is the type of investment that could most likely provide returns in excess of the loan rate. Or, if you invest in something that gives a known return, like a GIC, you will only get a much lower rate that will almost surely be less than the loan rate? Is the loan worth it, then? In my view, no.

As the months pass from March to the following February, the balance gradually shifts in favour of the loan option. At some point, the loan will be the better option. I have not tried to calculate the exact month when it looks better - perhaps half way, after six months, is a guess. But don't put off the contributions just for that reason. The February contribution scenarios all come out ahead of the March contribution scenarios. Putting the power of compounding to work as soon as possible by contributing sooner is the most important principle of all.

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
  

UK Car Loan Tricks and Tips

I've just finished helping a family member buy a car here in Scotland. The experience has been uncannily similar to that which occurs in Canada, a disagreeable negotiating process in which one feels taken advantage of, no matter how much of a price reduction one manages to negotiate. The less one likes cars, the better one is likely to do in negotiations since the dealers prey on our emotions - liking a particular car - to extract the most from us. There are a couple of things that arose in the buying process which I found especially dangerous to the consumer and which may save others lots of money. In our case, buying a car of around £8000, it made a difference of £650 in financing costs.

Tip - Get Prepared before Going Shopping
Duh? Perhaps this is too obvious to say, but doing a few hours research before leaving the house will save you money, will give you a car that satisfies your needs and should make the whole business much less stressful. That means figuring out things like:

• a target price to pay, both in total and on a monthly repayment schedule
• current financing rates available in the market - consult websites like MoneySaving Expert.com,
• which cars fit into your price range, the comparative pros and cons of those cars - buy What Car? magazine.

It also means reading up on the car dealers' sales tactics and how to counter with some of your own - e.g. how to do the good guy/bad guy routine to the dealer. Doing this stuff can actually start to turn the whole anxiety-ridden negotiation process into a kind of fun game, once you begin to feel on even terms with the dealer. Check out Car Buying Guide for some advice in that regard.

The above websites have a lot more detail and cover other important car-buying topics that really helped us.

Trick - Beware of Flat Rate Interest Calculations
Caution!! When we asked for financing rates at the dealer, the salesman initially offered us 6.0%. This sounded quite good, especially since bank loan rates currently start around 6.3%. This happened at all of the dealers we visited. One offered 5.25% and that sounded wonderful ... until we came home, did a little research at the above websites and discovered that UK car dealers will quote a so-called ''Flat'' interest rate on the loan that sounds reasonable but is actually about half the rate really being charged. In fact, car dealers are obliged by law, as regulated by the Financial Services Authority to tell the car buyer the real interest rate being charged, called the Annual Percentage Rate (APR). If we had gone through with a loan from the dealer we would have found out the APR but during discussions with the salesman, he was unwilling to tell us the APR. Note that APR is simply a normal amortized loan formula, whereby the interest is charged only on the declining principal balance as each month's payments reduces the principal over the term of the loan. APR is the only way to properly compare the cost of loans of differing terms and amounts. The same Flat Rate, on the other hand, will have a slightly different APR depending on the term or the amount (see my little comparison table image for an illustration of this).

This page of the Car Buying Guide shows step by step how the Flat Rate is calculated. It turns out that the Flat Rate charges interest on the total initial amount of the loan for every month of the term. If you borrow £8000 at 5% for 3 years then you get charged interest of 0.05 x £8000 = £300 / 12 months = £25/mo. each and every month for 3 years. A good graphical illustration and explanation of what is happening can be found here at MoneySavingExpert.com. What an unfair and deceptive way to charge interest!

Car dealers live in the real world too and they make more or less money on the basis of APR - more if the APR on the loan to the buyer is higher, less if it is lower. But their financing profit on a loan that is close to double the going best loan rates is perhaps more than the profit on the mark up of the car itself. So maybe they don't care about the fact that they make a slightly lower rate of profit (as measured by APR) on a five-year loan than on a three year loan.

Maybe they don't care but I think the real reason is that few car dealer sales people probably realize what they are doing and how the rates work out. Apart from the devious way it presents a seemingly lower rate of interest, the main characteristic of the Flat Rate method is its simplicity in terms of doing the calculation. No more than a calculator with big buttons and arithmetic functions is required, a definite plus when it comes to training sales people who may not even have finished secondary school (at one dealer we visited, the trainee salesman was a bricklayer who had decided to change occupations). By contrast the proper APR method requires calculating discounted cash flow (see the Wikipedia entry for the amortization calculator ). Ask yourself whether the average car sales person you have encountered could work out an APR payment. In fact, even the Flat Rate method seems to challenge some car dealership personnel as we were told by one sales manager a monthly payment amount for a supposed 5.75% Flat Rate that came out at 19.5% APR, which is not possible if done right. By the way, this reinforces the advice on those car advice websites cited above that one should always check the dealer's calculations for errors. Probably the sharp car dealership owner who invented the Flat Rate method realized that the combination of calculation simplicity and subtle consumer deception makes for a really useful sales tool.

In retrospect, we should have been suspicious of being offered financing on the spot without any credit check whatsoever by the dealer. The high Flat Rates likely more than offset the dealers' costs of bad loans to poor credit risks and give them the leeway to use this sales tool willy-nilly.

Tip - The Bank Won't Give You Its Best Deal Unless You Ask
Once we had figured out what was going with Flat Rate financing and that the rates at dealers were much too high, we visited our local bank branch of a major UK bank, where the car-buying family member has had an account for years. In other words, she has been a loyal customer with a stable job and a high credit rating.

So what was the initial offer - this time quoted in APR terms, hooray! - from the bank when we enquired? Answer: a measly 9.9%! Then we asked why we should not borrow from one of the on-line offers of other major banks on the MoneySupermarket website, whose range started at 6.3% and where the majority seemed to be around 6.9%. We left the bank and the manager promised to ''see what he could do''. Within a few hours he called back saying that lo and behold, the bank would now match the 6.9% rate because she was such a good customer and such a good credit risk. As they say, ''get me a bucket, I'm gonna be sick''.

After declining the bank's solicitation to also take out repayment insurance in case of accident or job loss - i.e. to pay more so that the bank could be sure of receiving the money, it was a done deal. The attached chart shows the net saving of £652 in total interest costs during the 3.5 year term of the loan over the dealer's initial financing offer, £470 over the bank initial offer and £442 over the dealer's best offer. That's a lot more than the £250 we managed to obtain as a reduction on the actual price of the car.

Bottom line, it's worth spending considerable effort on financing when buying a car.