RRSP Loan: Benefits and Drawbacks
Drawing an RRSP loan can be a smart way to invest in your registered retirement savings plan, provided your RRSP contribution room allows it.
While an RRSP loan may help you save on taxes and build your retirement savings, it’s important to remember that it’s still a debt. Carefully evaluate how much you’ll save in income tax and whether the RRSP’s growth rate is likely to offset the interest rate you’ll pay on the loan.
What is an RRSP loan?
An RRSP loan is a way to borrow money in order to contribute to an RRSP. Since it’s a loan, you’ll pay interest to the bank, credit union or investment company that lends you the money.
Because RRSP contributions lower your taxable income, using an RRSP loan may reduce the income tax you owe, potentially resulting in a tax refund.
If you do end up taking an RRSP loan, it’s recommended that you use any tax refund to pay off part of the loan right away. You can make payments on any remaining loan amount over the term.
Types of RRSP loans
Many financial institutions offer RRSP loans for terms ranging from 1 to 10 years. These products may be labelled as:
Short-term RRSP loans: With a term of around 12 months, these loans typically let you borrow a smaller amount you can contribute to your RRSP right away.
Long-term RRSP loans:Â With terms of up to 10 years, these loans usually offer a larger sum so you can catch up on RRSP contribution room from previous years.
How RRSP loans work
Here’s an example to illustrate how you’d use and repay your RRSP loan.
Note that we’ve used a simplified refund amount for this example. Any potential tax refund will depend on factors like income, province or territory of residence, and other tax credits and deductions.
Let’s say your income puts you in the 40% tax bracket.
So far this year, you’ve made an RRSP contribution of $1,000, but you have $4,000 contribution room left.
You take out a short-term RRSP loan to max out your account, which results in a tax refund of $2,000.
If you apply your refund to your loan, you’ll need to pay back $2,000, plus interest, over the next year.
If you’re paying 4% interest for the loan, but your investments generate a 6% return, you’ll come out ahead.
But, why should you go through all that trouble to max out your RRSP each year?
The idea is that you’ll contribute to your RRSP during high-income years, when you’re in a higher tax bracket, and get a tax break. When you eventually withdraw the funds in your retirement years, you’ll hopefully be in a lower tax bracket. This strategy aims to reduce the overall amount of tax you pay over the course of your life.
Reasons to consider an RRSP loan
RRSP loans are appealing for two reasons.
First, contributing to your RRSP means you’ll get an immediate tax break. Second, the contribution has long-term growth potential, depending on your investment strategy.
Generally, if the RRSP’s growth rate is more than the interest rate you’ll pay, the loan can make good financial sense. It’s even better if your tax refund is enough to pay off the borrowed amount before any interest starts accumulating.
How to qualify for an RRSP loan
Each lender has different eligibility criteria for RRSP loans, but generally, they’ll look at the following:
Credit score. You’ll likely need a good credit score (around 660) to be considered for an RRSP loan.
Income. Lenders will need to see that you have the ability to repay your loan.
Existing debt. Your current debt load could affect the size of the RRSP loan you’re offered.
To apply for an RRSP loan, you’ll typically need to speak with a representative over the phone or in person at a branch. However, some financial institutions and online banks accept online applications for RRSP loans.
Benefits and drawbacks of RRSP loans
Despite its benefits, an RRSP loan may not be an ideal solution for everyone. Like most methods of borrowing money, RRSP loans have both pros and cons, and it’s important to understand them before applying.
Benefits of an RRSP loan
Tax breaks and growth. Contributing to your RRSP gives you a tax deduction and the opportunity for long-term growth.
Flexible limits. Many financial institutions allow you to borrow up to $50,000; you can use the funds for the current year or to catch up on missed contributions from previous years.
Flexible terms. The term of the loan is usually between 1 to 10 years.
Deferred repayment. Some RRSP loans have a 90 day grace period before repayment starts, which should give you enough time to get your tax refund.
No prepayment charges. You can usually make extra payments at any time without incurring any penalties, allowing you to pay off the loan faster and save on interest.
Drawbacks of an RRSP loan
Savings may be limited. If you’re in a lower tax bracket, the amount of money you’ll actually save using an RRSP loan may be minimal.
No guarantee of higher returns. The investment returns must outpace the interest you’re paying to make an RRSP loan worthwhile.
Can only be used for RRSPs. Focusing on your RRSP doesn’t make sense if you have outstanding high-interest debt, such as credit card debt. It’s a better idea to pay off that debt first before borrowing more money to invest.
It’s another form of debt. Even when used strategically, an RRSP loan is still another debt to repay. Consider budgeting for regular RRSP contributions instead of taking on more debt repayments.
Is an RRSP loan a good idea?
An RRSP loan may be ideal for high-income earners who find themselves in a higher tax bracket. If the math works out, using an RRSP loan can be an effective way for those with limited cash on hand to secure a tax benefit and maximize their contributions.
However, an RRSP loan strategy only makes sense if your investments outpace the interest rate you’re paying on an RRSP loan and if the payments fit into your budget without hurting your cash flow.
Make sure to cover all your bases, or consider speaking with a certified financial planner for personalized advice tailored to your situation.
Frequently asked questions
How does an RRSP loan work in Canada?
How does an RRSP loan work in Canada?
An RRSP loan allows you to borrow money for the specific purpose of contributing to a registered retirement savings plan.
Do you need good credit for an RRSP loan?
Do you need good credit for an RRSP loan?
Yes. As with any bank loan, lenders will typically look for RRSP loan borrowers to have a credit score of 660 or above.
What is the difference between an RRSP loan and a line of credit?
What is the difference between an RRSP loan and a line of credit?
The main difference between an RRSP loan and a line of credit is the flexibility. For RRSP loans, you are required to apply each time you need to borrow funds. You’re usually expected to pay a fixed interest on the borrowed amount and repay the sum in a specified period. For RRSP lines of credit, once you’re approved for a predetermined credit limit, you can continue to borrow in future years and pay off at your own pace. You only pay interest on the amount you borrow.
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Siddhi Bagwe
Siddhi Bagwe