Tuesday, 15 January 2008

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.

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