Many Canadians wonder whether or not they should borrow money to help them maximize their RRSP contributions. Never was this idea touted more than in 2002 onward when interest rates were very low. There is no reason why it is not a good idea now, and interest rates are still historically low. This article, “Should clients borrow to catch up on RRSPs this year?” discusses why it can be a good idea.
Even though many experts discourage the use of long-term RRSP loans, most people would actually benefit from them, claims Talbot Stevens, a London-based financial educator, author, and industry consultant.
“If you just look at the math, RRSP catch-up loans always make sense when investment returns match or exceed the cost of borrowing,” explains Stevens. “If you can borrow at 6% interest and get returns of 6% or higher, you will come out ahead by borrowing to catch up on RRSPs, even if it takes 10 years or more to repay the remaining balance of the loan.
He does not go into detail here but the math is fairly simple. If the return in your RRSP matched the interest on the loan, the amount the RRSP increased by in the first year would match the amount you owed in interest on the loan. Once you take into account the tax refund that will be generated due to the RRSP deduction (at your marginal tax rate multipled by the amount of the deduction) you can see that you will wind up ahead. But I am neglecting something. We will be taxed on the RRSP’s returns later, when we withdraw it. This will reduce our effective return inside the RRSP. Not only that but we will be taxed on the contributions we made as well. The math does get a bit complicated, and it is always made even more difficult by the fact that it is impossible to predict future returns on an investment inside an RRSP. As the author of the quoted article says, however, behavioural factors are often overlooked when considering the advantages and disadvantages of borrowing to invest in your RRSP:
Stevens also likes the investment discipline afforded by long term RRSP loans. “When you also account for the behavioural reality that most investors spend their RRSP refunds, the scales tip heavily in favour of long-term RRSP loans, even when returns are half of the cost of borrowing,” says Stevens.
“For most investors, the catch-up RRSP strategy generally produces a larger retirement fund because the loan locks in a higher level of commitment. Once started, the loan becomes a forced savings plan, like a mortgage, where we don’t have a choice but to continue the payments.”
At first I did not understand what “the behavioural reality that most investors spend their RRSP refunds” had to do with the scales tipping “heavily in favour of long-term RRSP loans.” I think what he means is that if you have a long-term RRSP loan, you will be less-inclined to spend (in other words, waste) your RRSP refund. Instead you will be more likely to put it down towards the loan in an effort to lower interest payments and/or get rid of the debt sooner. Of couse it is better to contribute to your RRSP with cold-hard cash, but if you cannot maximize your contributions with cash, there does not seem to be anything fundamentally wrong with getting an RRSP “catch-up” loan.
Of course most of the arguments for and against borrowing to invest in your RRSP also apply to the pay down your debt vs. contribute to your RRSP argument.