The Registered Retirement Savings Plan (RRSP) is a highly popular registered savings account that is used by Canadians to save for their retirement or other things like a down payment on a home. The general idea of a retirement savings plan is to gradually build up a large sum within your account during your working years that you can then draw on to fund your living expenses during your retirement.
Those who are especially proactive will try to max out their yearly contribution each year before the deadline in March of the following year. Beyond just adding money to your retirement fund, contributing to your RRSP can also offer you great tax benefits as any amount contributing can be deducted from your taxes (and potentially help with your tax).
With so many people eager to max out their RRSP contributions each year, banks and other lenders have devised a product to help out those who don't necessarily have the funds on hand to do so. These are RRSP loans. You have probably seen these loans advertised, especially around this time of year as banks like to push their RRSP loans in advertising. But are they actually a good idea for someone who doesn't have the cash to max out their RRSP, or are you better off avoiding these RRSP loans?
How does an RRSP loan work?
RRSP loans work like any other loan from a bank: they provide you with funds now and you pay off the loan with interest over a set period of time. However, there are a few quirks of the RRSP that allow these loans to have some added appeal.
Why choose an RRSP loan?
For many people, they take out a loan on something they need now, like a down payment or a car. However, if you are saving for retirement, you may not need this loan for a long time. If you are investing it, you can see the equity of that investment grow far beyond the principal and interest costs of the loan, given enough time.
In addition, money contributed to your RRSP, even if acquired through a loan, is deductible from your taxes. This means you can potentially get a tax refund for taking out a loan which you could potentially put towards paying down some of the loan.
Most RRSP loans are borrowed at or near the bank's prime rate and have relatively low standards for approval. You can usually get a loan for your current year's contribution room, or a larger loan to top up from the previous year's unused contribution. These larger loans tend to have longer repayment periods (up to 10 years) but also come with a higher interest rate.
In most cases, banks will allow you a delay on payments for about three months so you can collect any tax returns that may be coming your way, so you can contribute them to paying off the loan itself.
Why do banks offer RRSP loans?
You should also remember that banks don't simply loan out money because they like you. They want to make money on the deal as well. Naturally, you will be paying interest on your loan. Depending on the amount you borrow and how long it takes to pay it back, the bank can make a lot of money from your interest payments.
In addition, since you are essentially paying your bank to invest money with them, they get to make additional funds from their investment fees.
Finally, by encouraging its clients to invest in their RRSP, they encourage regular RRSP contributions, leading to further investments and potentially future loans.
Is an RRSP loan a good idea?
The question of whether or not you should take on an RRSP loan is going to depend a lot on your individual circumstance. For some, it can be a smart choice to boost your RRSP quickly. For others, it may not be the best choice.
The cycle of RRSP loans
A lot of people are drawn to RRSP loans when they don't have enough cash on hand to max out their RRSP for the year. The issue is that taking an RRSP loan doesn't necessarily solve this issue, but merely pushes it to a later time. When the next year comes along, unless your saving skills or income have improved, you will probably have spent your money servicing your RRSP loan payments rather than saving for this year's contribution.
This can lead to a continuous cycle of borrowing to top up your RRSP every year; a cycle that will eventually have to be broken. For some, this may not actually be a bad thing. If you have struggled to maintain the discipline to save regularly, a monthly loan payment may just be the motivation you need to force yourself to save. However, you are also putting yourself at some risk by taking on a loan and potentially losing money to interest that you could have saved instead.
How much will it affect your tax refund?
Another major appeal of RRSP contributions – your tax refund – should not be taken for granted. In general, the amount of a refund you get for maxing your RRSP is going to depend on your individual tax bracket. Generally, a borrower in the highest marginal tax rate will stand to benefit the most on their tax return as the result of an RRSP contribution, whereas those in a lower bracket do not stand to gain as much of a tax-saving from maxing their RRSP contribution. Banks may advertise potential returns with their RRSP loan without mentioning the tax bracket requirement, meaning that the sizeable return they claim is not guaranteed.
For someone with a lower tax bracket, therefore, it may not be worth it. For example, their money may be put to better use by paying off high-interest debts like credit card debt to free up cash flow that can go towards contributions.
Investment strategy: RRSP loan vs. gradual RRSP contribution
You can also look at an RRSP loan in terms of investment strategy. For example, provided you can afford to pay regular payments towards your RRSP loan, why not simply contribute that money directly to your RRSP instead? Well, the RRSP loan will allow you to contribute in a lump sum, which means more time on your investment and greater potential returns.
On the flip side, you will need to pay an interest rate on that lump sum for however many years you have agreed to pay off your loan. Your investment will have to out-perform the interest rate you are charged while the gradual direct payments do not have this downside.
The bottom line
In general, RRSP loans may be a good option in a few cases, it is generally advised to forgo the loan and contribute directly to your RRSP as much as possible. Ultimately, the viability of your RRSP loan is going to depend a lot on your personal financial circumstances and investment strategies. If you are considering utilizing an RRSP but are unsure, consider talking to a financial planner or tax professional for professional advice.