There are many people, me being one of them, who ask themselves “should I put money into my RRSP or pay down my debts?” For very high interest debt, such as credit cards and brank overdraft, this type of debt should always be paid down before anything else. For other debt such as student loans, bank loans, and mortgages, the answer is less obvious.
I have come up with a good, simple example, to answer the above question. Imagine you had at least $1000 room in your RRSP and you owed $10,000 at 7% as of January 2006. In January 2006, you have a choice of either putting your next paycheque (of $1000) towards an RRSP invested in a balanced portfolio of bonds and equities, or towards the $10000 loan. You can do nothing else with your loan or your RRSP until January of the following year.
- Case 1: If, in January 2006, you put $1000 towards the $10,000 loan, you would be left with $9,000. Over the next year, you would be charged $630 in interest, a savings of $70 over what you would have paid had the loan principal still been $10,000. Your net worth based on the RRSP and the loan would be -$9,000 - $630 = -$9,630 at the end of the year.
- Case 2: If, in January 2006, you put $1000 into the RRSP invested in a balanced portfolio of bonds and equities. We can assume that on average this portfolio should average at least 7%, but to be conservative, we will assume that it will appreciate by 7%, however, it doesn’t really matter so much as we will not be realizing any value on this portfolio for years to come (until we retire, presumably). After one year, the RRSP portfolio will have appreciated by $70. In April 2005, you will receive a tax credit. Assuming a marginal tax rate of a modest 18%, you will receive $180 in April. You can then apply this to your loan in April. Let’s keep the calculation simple and just hold it as cash until the end of the year (not the best thing to do in practice). During the year, our loan accumulates $700 in interest. At the end of the year our net worth will be -$10,000 - $700 + $1000 + $70 + $180 = -$9,450.
In Case 2, we are $180 richer than in Case 1. This came directly from the RRSP tax credit as the amount the RRSP holdings grew was exactly compensated by the extra amount we owed on the loan. This demonstrates the power of RRSPs. One strategy is to contribute monthly to your maximum allowable limit, then to apply the tax credit in April to your loans. The tax deducted from your paychecks acts as a forced savings device for an annual loan principal payment.
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