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Reader Mail: RRSP Loan… Yes or No?

Angel emailed me to request some personal finance direction. Angel is basically wondering if it would be wise to get an RRSP loan and use the tax refund to pay down the car loan.  Here are more details:

I'm a 22 year old from Winnipeg, MB.  I make about C$35,000 (pretax), and have no debt, other than my car loan (~$7000 @ 11%).  I'm got the equivalent of a month of expenses in Savings, and I just started saving about $100 in RRSPs every month. Since I had not done any contributions previously, my RRSP limit is about $10,000.

I was told by a friend that I should get a $10,000 loan (@ prime) and put that money on my RRSPs, and use the tax deduction to lower my car loan balance.  Does this make sense to you? I understand that you're not a financial advisor. 

In MB for 2007, the first $30,544 of income puts your tax rate @ 26.4% and $30,544->$37,178 has a tax rate of 28.50%.  With that said, making $35,000 gross puts your tax rate @ 28.5%. 

If you were to get a $10,000 loan, you would get a refund approximately (28.5% x 5000) + (26.4% x 5000) =  $2745.  This would account for less than half of your car loan.  Not only that, since you're in a lower tax bracket, your return is not optimal.  There could be arguments that you'll have half of your car loan paid off, along with a good start to an RRSP (compound growth over the years).  Especially since you are young.  However, you are still left with an RRSP loan of $10,000 @ prime on top of $4,200 @ 11% left on the car loan.  Now you face 2 payments, the regular car payment + RRSP loan.

If it were me, not unless your rrsp contributions are employer matched, at your current tax bracket I would stop RRSP contributions. I would then put all contribution money and extra savings towards the car loan.  The reason being, @ 11% interest, paying down the car loan is equivalent to a 14% pre-tax investment return at your marginal rate.  In a couple years when you jump tax brackets and your car loan is paid off, I would take your former car payments + cash flow and max out the RRSP (as much as possible anyways).

Personally, there are very few scenarios where I see RRSP loans beneficial.  The one case where I do like RRSP loans is where the loan "tops up" your RRSP contribution and the tax refund pays back the loan entirely. 

Any thoughts? 

Any financial advice that I give should be taken as opinion only and not as professional financial advice.

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 20 comments… add one }
  • The Financial Blogger September 13, 2007, 9:19 am

    I agree with you. There is no point to get more debt just to pay $2700 on a car loan at 11%.

    If she can afford a 10K rrsp loan, she is better off putting all her money on the car loan directly. Let’s say that both loans are over 5 years starting today (to make calculation easier). The car payment is at $152.20 and the rrsp loan payment would be at $195.26. Then, she could make a monthly payment of 347.46.She will pay off her car loan within two years. If the RRSP loan is over 10 years (I doubt she would get it at prime rate over such amortization!), the loan payment would be $113.11. Then again, if she combine the two payment to put all the money towards she would still pay her loan within 3 years (it’s much better than being in debt for 10 years!).

    I would also suggest that she invest her $100 per month into non-registered investment for now. Her tax bracket is not that high and she would create a bigger emergency fund. Since she is 22 and making 35K already, I assume that she has very good chance to increase her income in the future. Once she is in a higher tax bracket, then it would be the right time for a RRSP loan to catch up on her contributions.

  • Tom September 13, 2007, 9:35 am

    I have an example where I think a loan can work in your favour.

    We did an RRSP load once, when we were buying our first home. We were just short of a 15% down-payment, and at the time if we could increase our down-payment to the 15% level, we would save 0.75% of our mortgage value in mortgage insurance. For a $300,000 house, this translates to $2250. We borrowed $5000 and put it in our RRSP 4 months before our house closed. We then ‘borrowed’ the $5000 under the home-buyers-plan (HBP), which we’ll have to pay back into the RSP over the next 15 years. When tax time came, our marginal rate was 40% so we also got a $2000 refund, which we applied towards our loan. So we were left with a $3000 loan, which we paid off in a few months, making the interest payments negligible. As long as the amount you’re borrowing for the RRSP is not too significant, and you’re saving on the mortgage insurance, I think this is a good technique. It gets even better if you’re increasing from 0% down to 5% or from 5% to 10% down-payment (0% down mortgages are the worst!). When we bought our house 5 years ago, the mortgage insurance rates through CMHC were 3.75% for 5%-down, 2.5% for 10% down, 1.75% for 15% down, 1.25% for 20% down, and of course 0% for 25% down.

  • George September 13, 2007, 9:52 am

    I also agree that the car loan should be paid off before bothering with RRSP contributions. Right now Angel’s income is low enough to make the tax savings fairly minimal, and it’s quite true that the RRSP investment would have to exceed 14% yearly to match the benefit of paying off the car loan.

    One tip that’s often overlooked: If Angel wants to continue making RRSP contributions, and thinks that her income will go up into a higher tax bracket within the next few years, she can make the contributions to her RRSP now, but delay using the tax deduction until a future year (when it’ll be worth more).

  • FrugalTrader September 13, 2007, 11:20 am

    Great tips, glad that you guys agree with my analysis. :)

  • Angel September 13, 2007, 12:00 pm

    Thanks for the tips guys!!

  • Bryce September 13, 2007, 12:13 pm

    Also, I’d look at refinancing that loan. If she truly has no other debt she should be able to get a loan for less then 11%.

  • Rod Payne September 13, 2007, 2:03 pm

    Angel:

    Are you in any way able to claim the use of your car for business purposes at your place of employment? If so, you may be able to turn a portion of the “bad” debt into “good” (i.e. tax-deductible) debt.

  • Angel September 13, 2007, 2:12 pm

    Rod:

    Unfortunately, I can’t, but that would be sweet!

  • tom September 13, 2007, 2:38 pm

    I agree with Bryce. She should shop around for the lowest interest rate on a new loan and use it to pay off the car. Why was the car loan rate so high in the first place?

  • Warren September 13, 2007, 2:59 pm

    I agree that paying off the car loan should be a priority. I paid off a mortgage rather than contributing more to an RRSP. But it leads me to a related question: When do RRSP carryover amounts from previous years expire? Do they ever? I was recently checking my records online, I’ve been filing a tax return since 1997, and had extra room every year. From what I can tell, none of this extra room has expired (yet).

  • Rod Payne September 13, 2007, 3:01 pm

    RRSP carryforward room never expires.

  • FrugalTrader September 13, 2007, 3:03 pm

    Warren,

    To my knowledge, RRSP contribution room will carry forward indefinitely.

  • George September 13, 2007, 3:45 pm

    You can indefinitely carry-forward RRSP contributions to be deducted in a future year. You can also carry-forward unused contribution room indefinitely. Or at least until the budget is changed to limit the amount of carry-forward, but such a budget change is unlikely (very few people make use of their unused contribution room).

  • WhereDoesAllMyMoneyGo.com September 14, 2007, 2:35 am

    You need to consider the effect of not putting that money in your RRSP (or other investment account) now and what growth you forego. If you are 22 and put in $10,000 now, assuming an 8% rate of return and 43 years of growth (to age 65) then you are foregoing $273,666, but that is assuming that you don’t top up at a later date, so the foregone growth wouldn’t be nearly as high as that.

    You also need to consider that if you put in $10,000 as a lump sum now and you don’t have the cashflow to make additional contributions to your RRSP then you will build up contribution room for the duration of time you are paying back the RRSP loan yet again – thus potentially prompting you to “catch up” again with another RRSP loan.

    If you plan on maximizing your RRSP long term (i.e. using all available room as it becomes available) then you don’t have any pressing need now for an RRSP loan, IMHO.

    But, if you have company matching to your RRSP then I would maximize your monthly contributions to your RRSP as best you can and use the annual refunds to pay down the car loan. If they reduce tax withholing at source though, this can backfire in that you will make bigger contributions but you won’t have a refund at the end of the year.

    Personally I think it is nice to get into the habit of saving 10% of what you make and put that into long term savings no matter your debt – just so you get into the habit of doing so. Many people will pay down the car loan aggressively and then find something else to buy or finance instead of “finally starting” their savings – that’s how most people get behind.

    If you can still pay down the car loan aggressively with 90% of your income as your budget then more power to you – the logic is that there are people earning 90% of what you make per year who are the same age with a similar car loan and they manage to make do. It applies to all income levels. Somewhere out there is someone making 90% of what you are making and they have all the same “stuff” as you – so if they can make do, so can you – and you will have the added benefit of staring your automatic long term savings plan…

    Just a thought…

    In the end, many financial decisions are subjective – and in any case you are doing the right thing by asking about saving when you are so young.

  • Cannon_fodder September 14, 2007, 7:09 am

    “But, if you have company matching to your RRSP then I would maximize your monthly contributions to your RRSP as best you can and use the annual refunds to pay down the car loan. If they reduce tax withholing at source though, this can backfire in that you will make bigger contributions but you won’t have a refund at the end of the year.

    Personally I think it is nice to get into the habit of saving 10% of what you make and put that into long term savings no matter your debt – just so you get into the habit of doing so. Many people will pay down the car loan aggressively and then find something else to buy or finance instead of “finally starting” their savings – that’s how most people get behind.”

    Reducing the tax withheld at source might be an easier way to get into the habit of paying yourself first. You would discover additional money at each paycheque which should be applied initially to the car loan. Once the realisation of how easy it is to do this without any impact on the lifestyle, then it may be a small step to start diverting additional money to other initiatives (paying down debt, savings, investing, etc.).
    Some people can handle (and need) big steps and radical changes, while others are more likely to be successful with gradual modifications to their behaviour.

  • Q Cash September 14, 2007, 8:11 am

    I agree with Cannon Fodder.

    Getting in that habit of putting the money away is probably not a bad deal. At $100 per month, you are not going to miss it, but you are in the habit of doing it.

    My advice would be to try to match what you are contributing to the RRSP with additional payments on the car loan (i.e. find an additional $100 to “fast track” the car payment loan).

    Also, I wouldn’t worry about RRSP loan just yet, but I would shop around for a better car loan rate.

    Q

  • Rod Payne September 14, 2007, 12:15 pm

    While I agree with the consensus here that debt reduction and savings habits are long term strategies, there is one more factor that should be added in the short term. Angel has made no reference to having an emergency fund, so I think the first order of business for her would be to divert some money to building one. With cars come unexpected expenses (often at inopportune times). I think first order of business is for her to amass $500-$1,000 as a buffer before she starts work on the strategies above.

  • Angel September 14, 2007, 12:31 pm

    Thanks to all for all the comments!!!

    @Rod Payne: I’ve got about a month of expenses in Savings right now, and I treat it as my emergency fund.

    @Tom Venner: I didn’t really have any credit history prior to this car loan, so I got stuck with a really high rate :(

    I’m so glad I asked for advise before doing anything. I guess sometimes you just have to go with the good old “if it’s too good to be true, then it probably isn’t right”.

    Thanks again!

  • Rod Payne September 14, 2007, 12:46 pm

    Angel:

    Is it possible that you are overinsured on the car? For example, if your deductibles are low ($250/$500), would you file a claim for $600? Knowing what would happen to my rates if I did make such a claim, I upped my deductibles (increasing my risk exposure). The difference might only be $15-20 per month, but it’s money that you are now spending that you will never benefit from.

    Note: this is not a recommendation to go out and roof your deductibles; just something to consider. The only reason I mention it is due to the presence of your emergency fund.

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