As we are in RRSP season, you’ll see banks promote RRSP and along with it, a RRSP loan which is a special loan you can use towards your RRSP contributions. The banks make the RRSP loans sound very attractive but in reality, it is only beneficial for a few people. As a financial consultant for 10 years, I typically do not recommend an RRSP loan for the average Canadian. Read on to learn why and hear my thoughts on alternatives.
An RRSP loan is a type of “borrow to invest” where you can borrow this special loan to use towards your RRSP contributions. It’s easy to approve and the interest rate is low making it attractive to consumers. The ideal scenario is that you take this loan to put towards your RRSP gaining a boost in your tax return, then using the tax return to pay off a portion of what you borrowed. The first payment is usually deferred by 90 days so if you take the loan out in February before the RRSP deadline, you can generate a tax refund in April to pay down a portion of your loan.
In theory, the RRSP loan is an option that gives you a better tax return and gives you some time.
There are two scenarios where an RRSP loan makes sense:
In these two cases, an RRSP loan can help you to defer tax, top up your RRSP contributions and save income for your retirement.
Here’s an example of a scenario where you might want to consider an RRSP loan. Julie is in the 40% tax bracket with $10,000 ready to contribute to her RRSP before the deadline but still has $50,000 room remaining in her RRSP. Julie can consider borrowing an additional $40,000 from the RRSP loan to top up her RRSP which would get $20,000 back in tax returns. Then, she can use the $20,000 towards her loan and pay off the remaining $20,000 over the course of the year leaving her with $50,000 in her RRSP account.
In the past 10 years, I find most who have an RRSP loan fall into the following situations that do them more harm than good. If you see yourself falling into any of these scenarios, it’s best to avoid getting an RRSP loan and consider an alternative which I’ll cover later in this post.
The core problem with RRSP loans is that usually you don’t have enough money to contribute so you end up borrowing, but this leaves them busy paying off this loan all year. Come the following February and RRSP season, they’re back in the same situation with not enough money to contribute to RRSPs and so they take another loan. With banks offering a loan period up to 2, 5 and 10 years, many find themselves playing catch up over and over again. The RRSP loan is meant to top up, not to play catch up!
Consider this: If you don’t have the discipline to contribute to your RRSP regularly throughout the year, how do you expect to stick to a loan payment over the next 12 months? Or, if you do not have the discipline, consider contributing to your RRSP regularly throughout the year rather than an RRSP loan.
For your RRSP loan, you have to pay both principal and interest together per month. For those who are thinking of getting a mortgage or need other loans, the bank will look at your total debt service ratio, or the TDSR, when you are looking to borrow. This refers to the percentage of your income you are allowed to use for housing or car leases and the portion of a borrower’s gross monthly income that goes towards repaying monthly obligations including your loans. The magic number is 40-44% meaning your monthly debts cannot exceed more than 40% of your monthly gross income.
Using the previous example, let’s say you are paying $2,000 a month to pay off the RRSP loan, and your income is about $10,000 a month, that means the RRSP loan is eating away 20% of your TDSR.
Sometimes an RRSP loan might not be reflected in the credit bureau, but would you like to take that risk when you are applying for your next mortgage?
An RRSP loan limits your cash flow for the next 6-12 months because that is the usual timeframe it takes to pay back your loan. Consider this: even if you “only” need to pay $250 a month towards your loan, that’s $250 you can’t use for anything else. What if something unexpected happens? Any extra payments around the house of car repairs could be a risk to you. In the end, you might have to borrow even more money – like a line of credit or owe a credit card balance with much higher interest rates. Or you have to take out from your RRSP again, which adds on your this year’s income.
As you can see, RRSP loans can quickly turn into a vicious cycle.
I am a person who also believes in borrow to invest, but an RRSP loan is not the best idea in many situations. However, here are some alternatives that you might want to consider instead.
You should always talk to a professional to see which strategy works best for your situation and an RRSP loan can still be good in some cases. Book a consult with me and I can better assess your specific situation.
I’ll leave you with some questions to think about before getting an RRSP loan:
Be aware that especially during RRSP season, banks are playing to our needs of instant gratification with their well-timed RRSP marketing. But an RRSP loan isn’t necessary if repaying a loan doesn’t fit into your financial plan, or if you already have the discipline to make regular contributions to your RRSP throughout the year.
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About the Author:
Thomas C.Chan has been advising for over 10 years and has built a reputation for his approach in developing personal finance strategies, setting up risk management, and accumulating wealth for Canadians.
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