RRSP Deadline Approaching: Should I Borrow to Contribute?
That's how many days remain until the 2014 RRSP contribution deadline.
This year, it's March 2, 2015.
Every year, it's the same thing. Once January 1st comes around, commercials and advertisements from the financial institutions on TV and radio are trying to convince people to borrow money to contribute in their RRSPs. Credit card companies are offering 0.99% interest rates until November 2015 in an effort to get you to borrow money to put towards your RRSP.
How noble of these financial institutions offering to help us with our retirement...
Seriously, what's the catch?
As much as we'd like to believe financial institutions are looking out for us, their primary reason for existence is to make money for their share holders.
So how are they doing that? Essentially, by taking a cut of our RRSP growth.
Let's assume you borrow $5,000 from the bank using an RRSP loan at 3.5% interest. Assuming your tax rate is 40%, you'll be getting $2,000 from the Government in the form of a refund.
Now, you're smart enough to know that this money isn't free money*. You have an RRSP loan to pay off, so you put this money towards that leaving you with $3,000 remaining to pay off.
The bank, being extremely generous, helps you set up an automatic deduction from your bank account. Each month, it will take $300 until your loan is paid off.
At that rate, it will take 11 months to pay off the loan while accumulating $45.20 in interest.
Wait... so why would a bank bother lending you money for $45.20?
Well, this is under ideal conditions. Some banks will allow you to pay off the loan with minimum payments, nothing as generous as 10% of the principal amount.
You'll be able to make payments towards the loan. However, if you had to borrow money to contribute to your RRSP (this means you didn't save monthly to contribute to your RRSPs during the previous year), what are the chances you'll set aside money to pay this loan?
Assuming you just need to pay off the interest, that's $8.07 a month... forever. If they can find 100,000 suckers, that's $800,000 a month in profits each month!
So how is this a cut of our RRSP growth? Well, this is money that was borrowed from the bank. Assuming you're not being silly and put that money in an RRSP high interest savings account that only pays 2.5% until April 1, 2015 (1.3% after), then the 7% growth (taking an average of 9% and subtracting 2% to account for inflation) you get from the stock market isn't actually 7% growth.
Let's assume you're smart enough to put the money in index funds and get an average return of 7%. With your initial investment of $5,000, that's a gain of $350!
Don't forget about your interest payments though. You only made the minimum interest payments after a year. That's $96.84 in interest from your loan.
Overall, you only had a net gain of $253.16... That's not bad you think.
Well, now your 7% return is only 5%.
That's quite the cut. That's assuming you put your refund against the RRSP loan. Let's assume your refund is now a leather couch.
That means your $5000 loan at 3.5% interest costs you $175.
Now your return has been reduced in half.
Bottom line, if you're going to borrow money to contribute to your RRSPs, you better pay off that loan as soon as possible.
If you want to avoid an RRSP loan, then paying yourself first is the best way to contribute to your RRSPs. You'll be using your own money to do so and all growth is yours to keep. At least until you take out the money... that's a story for another time.
While we're not using the pay yourself first approach, wifey's RRSP contribution is almost maxed and I have a fair amount contributed for 2014. With our refunds, we're going shopping!
We're going to get a jump start on our 2015 RRSP contributions.
*Shockingly, I've known people who borrow money to contribute to their RRSPs and then use the refund to buy electronics or take a vacation... Seriously? The bank was kind enough to put them on a monthly payment plan that increased the bank's profits.