Just a couple of weeks ago I received a letter in the mail from my friendly neighbourhood bank. “Get the money you need to build your RSP”. I was pretty much given a pre-approved $20,000 credit from the bank at a low interest rate of prime + 0%. Only prime plus 0%? That’s ridiculous. It’s almost like free money!
I then recalled the latest articles coming from all over the news about how Canadians are saddled with debt that on average equals more than 160% of their annual income. It’s not a surprise that banks are trying to give out more money in order to drive business growth. In fact that is how banks make money, loan money out and collect interest. These types of loans are just another example of how the banks are taking advantage of Canadians and their lack of cash flow.
The real question becomes, is it really worth it to borrow money to invest for retirement? I get asked a lot, “With interest rates so low, shouldn’t I borrow money and try to make a return greater than what the bank is charging?”
The Emotional Effect
In theory it makes a lot of sense to borrow with low interest rates and take advantage of returns that could potentially exceed the interest rate. But what happens when things turn south?
If you borrowed money last year you’d be fretting because the markets in Canada have tanked 20% due to the low oil prices. Would you be willing to take such a substantial loss with borrowed money? Probably not.
Using borrowed money to invest incurs great risk. The fact remains that many average Canadians do not like risk. We hate stocks. We don’t believe the government. We prefer to chase 3% high interest accounts rather than invest in companies that are generating billions of dollars in profit. That alone should tell you that borrowing money to invest is a bad idea. The only reason why we might even consider the thought is because of greed, but just remember that fear is greater than greed. In the end, we’re just not emotionally stable enough to handle it.
With average Canadians already at 163% debt-to-income ratio, it makes absolutely no sense to expose yourself to greater risk by leveraging even more just to contribute to RRSPs. Loans are not assets. Just because you can buy assets using borrowed money, doesn’t make a loan an asset. It still needs to be repaid.
Trying To Get Tax Breaks
It’s true that when you make an RRSP contribution, you get money back for the taxes you have already paid on the amount of the contribution, but using borrowed money just to get a tax refund is not a smart idea. Remember that an RRSP account is for tax deferral. That means when you remove money in the future from an RRSP you need to pay taxes on that withdrawn amount. Making a contribution now just to get a refund because you need extra cash flow is just borrowing money from your future self. Doesn’t that defeat the purpose of being a retirement savings account?
On top of that, you might not even be giving yourself a tax break. You have to pay interest on your loan. You may even go into a higher tax bracket in the future when you withdraw the money. This just means you are siphoning away even more money from your future self than you think. I know Millennials always talk about “living in the now”, but guess what, your future now will be nothing but debt!
There is only one reason why you should borrow for an RRSP, and really only one good reason. It happens when you excess contribution room, but don’t have enough cash to actually contribute. That’s when you want to top up your RRSP contribution with a loan so that you can use the refund from the borrowed amount to cover the loan immediately. What do I mean by that?
Take this example:
Let’s say you are in a marginal tax bracket of 35% you have $10,000 in contribution room but you only have $4000 to contribute in cash. You want to contribute more, but don’t have the cash. What now? Borrow it!
- Borrow $2153 right now and add it to your contribution. Why $2153? I’ll explain.
- Your total contribution is now $6153.00 rather than $4000.00
- Your tax return is now $6153.00 x 35% = $2153.00
Holy moly, your tax return equals exactly the same amount you borrowed! That’s right. You should use the tax return to repay your loan immediately. No, you don’t get to go to the mall. You don’t get to pay off credit card bills, or your heating bill, or your kid’s birthday present. It goes to pay the loan.
So now rather than having ($4000 + $1400) $5400 to invest, you now have $6153 invested in your RRSP. That extra bit that you put into the RRSP through borrowing can go a long way. It can sometimes be the difference maker between using the TFSA to invest versus the RRSP, but only if you know that you’ll be in the same or lower tax bracket in the future.
If you want to figure out how much to borrow, use the following simple formula (this assumes you are staying in the same marginal bracket):
amount to borrow = (contribution x marginal rate) / (1 – marginal rate)
Don’t Gamble Your Future
So what does this all mean? There is only a very specific case where borrowing to invest into your RRSP makes sense. There will be other many arguments that why you should borrow money. Many arguments made by your local bank institution is just an excuse to make you pay more interest. Remember, the bank is in it to make money off you. Not the other way around.
Be careful with overextending your debt in order to “get ahead”. There is no quick money making scheme. I’m not preaching the get rich quick scheme. Growing your retirement portfolio takes time. It is impossible that we will all be millionaires before we are 30.
Just be aware that the RRSP is a tax shifting account. You want to contribute money where you are paying higher taxes now to a future date where you pay lower taxes on withdrawal. If this doesn’t sound like you, because you have a defined pension, or you plan to have really good retirement income, then skip the RRSP and contribute to your TFSA instead.