How it works for investors
Borrowing money is so common that many Canadians likely do it without thinking twice about the risks. But it’s important to understand an RRSP loan before committing to one.
To borrow for an RRSP, you take out a lump sum at a modest interest rate, and put it into your RRSP investment, to maximize your contribution for the year. Then you repay the loan in installments. Most borrowers will also use the tax refund they net to make a significant principal payment.
In the best-case scenario, the tax refund borrowers receive will cover not just the cost of borrowing, it’ll also help knock out a big chunk of the principal — keeping payments manageable for the rest of the loan’s term.
Let’s say you borrow $10,000 at a three per cent interest rate. That will end up costing you around $165 in interest. But over the year, your investment earns five per cent — that means you’re coming out about $335 on top.
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If your RRSP is invested in stocks, you are effectively borrowing to invest in the market. This strategy, known as leveraging, is considered risky.
However, Tony Maiorino, the head of RBC’s Wealth Management team in Toronto, says it doesn’t have to be riskier than other loans. In fact, he started using the strategy when he was in his twenties and just starting his career.
“At the time … I had no idea where my career was going to go,” says Maiorino.
So he weighed his options and felt it would be riskier to potentially run out of money in retirement than to experience a loss today.
“I knew not having enough is way worse than a market decline tomorrow, because I believed I could make that up,” he says.
In fact, Maiorino still uses this strategy in a way. Now, he has a line of credit he takes from each month to top up his investments that he pays down as much as possible come the end of year — which means even if he’s short on cash one month, he’s still making regular and consistent contributions.
While it has worked for Maiorino, it’s not a strategy that works for everyone.
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Taking on more than just market risk
To borrow for an RRSP, all you need is to meet a minimum credit score. But although these loans are relatively easy to get, borrowers should be aware of the risk of a financial loss.
Say you borrow $10,000, invest in your RRSP with it, and the market tanks the next day. You’re still on the hook to pay back the full $10,000 — along with any interest you owe — even though your investments may only be worth $8,000 now.
“From a financial planning standpoint, it is definitely a higher risk strategy,” says Nico Wong, a financial advisor with BlueShore Financial in Vancouver.
Wong says he wouldn’t recommend this approach for DIY investors or people who don’t have a good sense of their own risk profile.
“At the end of the day, with the markets, there are no guarantees,” says Wong. “And the risk is borne by the investor.”
If that prospect will keep you up at night, this is likely not the strategy for you, Maiorino concurs.
Don’t rush into a decision
Mark Yamada, president & CEO of PUR Investing in Toronto, urges prospective borrowers to consider their cash flow. Although most should expect a tidy tax refund to pay down part of the loan’s balance, you may end up needing that money for more pressing things by the time the CRA issues your refund.
Says Yamada: “If … you’ve only got a couple hundred bucks at the end of the month, your cash flow is too tight to add another $250 for a $15,000 RRSP loan.”
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An alternative strategy
For those who could suddenly be short on cash, a simpler strategy is investing what you would have paid in loan installments each month. Not only will you avoid paying interest, but if your situation changes suddenly, you can reallocate those funds worry-free.
“If you have the discipline to do that, it's a far better way of doing it,” says Yamada.
Making sure an RRSP loan is the right strategy for you may take some research.
And if you’re feeling pressured into making a decision on a short timeline, chances are good you may not make the best choice.
“Go and spend $3 and get an ice cream cone and think it over,” says Yamada. “That’s a good investment.”
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