Me and My Money

Borrowing for an RRSP

Posted January 11, 2012
Originally Published January 9, 2012

6 Problems with RRSP loans

The staff at the branch where a close friend does her banking had a meeting sometime in late 2011 – or maybe they just received a memo from head office – either way, I can tell you the gist of the conversationdirective; get out there and sell RRSP loans.

I know this because the bank employee who has shepherded my friend and her husband, both in their early thirties, into RESPs, RRSPs, TFSAs, a mortgage and a personal line of credit (LOC), gave them a call.   Since he has their most recent notice of assessment on file, a requirement of the LOC, he is aware that they haven’t maxed out their RRSP contributions for years.  

The deadline for 2011 RRSP deposits is February 29^th and my friends have over $21,000 of contribution room each.   The bank employee suggested an RRSP loan to reduce their taxes and get a leg up on their eventual goal of an early and well-funded retirement.  He increased the pressure by noting that neither have a company pension plan so they really should max out their RRSP contributions annually. 

Of course, the bank wins both ways on RRSP loans by pocketing the interest on the transaction as well as the fees on the investments the advisor recommends, usually mutual funds.  That’s why thousands of bank advisers will be having similar conversations with clients over the next few weeks.

I couldn’t agree more with the points raised – except for the loan part.  Yes, my friend and hubby should contribute more to their retirement savings.  Yes, they will endanger their retirement if they don’t save a larger percentage of their income (right now it is about 5 percent but that includes RESP savings.)  And yes, a big contribution for 2011 will result in a fat refund cheque.   But can they handle the additional debt and, even if they’re able to, should they?

I say no, not only to my friend, but also to the majority of those considering an RRSP loan. 

Here’s the problem.  First of all, the interest on RRSP loans isn’t tax deductible, which helps ameliorate the cost of borrowing.   You could argue that the additional tax credit from the RRSP contribution functions the same way.  However, the second problem for all investment loans is that to make them pay off long term your investment return must be higher than your borrowing costs. 

Easy peasy, you might say.  Since interest rates are so very low it should be a no-brainer to eek out a return that is higher than the cost of the loan.   Let’s take a look at some broad stock market returns for 2011.

United States        2 per cent

United Kingdom  -2 per cent

Canada                    -12 per cent

Germany                 -15 per cent

India                         -24 per cent

If my friends had taken out RRSP loans at the beginning of last year and put the entire $42,000 into Canadian mutual funds there’s a good chance their investments would be down $5,000 or more (not including fees), as many funds underperformed the overall market, and they still have to pay back the loan plus interest. They might have chosen top performers but the returns for average investors, particularly those purchasing mutual funds, rarely exceed the market indices.

Of course, 2012 could produce positive double-digit returns across the board.  But who knows?

The third problem for those borrowing to contribute to RRSPs is about lack of discipline.  If you have the self-control to use your tax refund to pay down the RRSP loan and eliminate it completely by the time the next RRSP season rolls around, then the strategy could work.  But I find most people who get on the RRSP loan treadmill have a tough time getting off. 

The fourth problem with RRSP loans relates to other debt.  In addition to a mortgage and a personal line of credit my friend and her husband have a car loan at 6 per cent and credit card debt at 12 per cent.   The combination of RRSP investment returns and tax refund will have to be considerable in order for a retirement savings loan to make sense rather than paying off that higher interest debt.

The fifth concern for those considering an RRSP loan is taxable income. There’s no point in borrowing to contribute if you aren’t paying income tax.   Last week a stay-at-home Mom asked about taking out a home equity line of credit to contribute to her RRSP.  She can carry the contribution forward to higher earning years but as long as she has other debt (and she does) she’s going to be better off getting rid of it first.

A last caution about RRSP loans is for those close to retirement, by that I mean within a decade or so.  I frequently hear from those contemplating an RRSP loan to force feed their savings because they’re terrified about retiring with a meagre pension and a skinny RRSPRRIF.   Often they intend to downsize their home to pay off the loan if it is still lurking around by retirement. 

But this approach involves considerable risk.  What if real estate takes a tumble?  What if the market hits another bad patch?  What if interest rates jump?  All of these are possibilities so those who are within sight of retirement should try to reduce current spending in order to make contributions, rather than gamble on having more debt in retirement.

The siren call of an RRSP loan is hard to resist at this time of year.  But the risks can overwhelm the rewards.

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