What's an RRSP loan?

Written by Preet Banerjee

Monday, January 4th, 2016

 

It might seem odd to borrow money to save money, but that's the general idea behind an RRSP (known as an RSP at Tangerine) loan.

When the RRSP deadline approaches, some Canadians will take out an RRSP loan to make a large contribution before the deadline, which will hopefully result in large tax savings in the short term.

If you're a regular saver, an RRSP loan may be something you never consider, since you're already consistently saving for your future. But most people use RRSP loans to catch up on contributions they wanted to make, but never got around to.

An RRSP loan works just like any loan: you borrow a lump sum of money and have to make principal and interest repayments regularly over a period of time. The only thing that makes it an RRSP loan is that the lump sum goes directly into your RRSP account.

RRSP loans tend to be shorter than other types of loans. A car loan might be five years or longer, but generally RRSP loans would be much shorter than that. They often include a deferral on when the first payment has to be made, too. For example, if you take out an RRSP loan in February you might have the option of not making the first payment until three months later. That might be enough time to file your taxes, claim the RRSP contribution, and generate a tax refund. That refund could be used to reduce the loan balance and, depending on the loan provider, give you the option of a lower monthly payment than originally planned.

Some Canadians use RRSP loans as a means of forcing themselves to save for retirement. If they saved on a monthly basis, they may be tempted to stop the automatic contribution at any time. But if they commit to a loan, they are much less likely to miss a loan payment for fear of defaulting.

Sometimes that leads people to getting an RRSP loan every single year. We pointed out the problem with that approach at the beginning of this post. There is a cost to borrowing money which offsets some of the potential gains from investing.

Normally, interest rates on RRSP loans are low, but they are never free. If you feel tempted to take out an RRSP loan every year because you feel that's what keeps your overall contributions higher, just remember that if you're making an automatic loan payment or making an automatic contribution, there's not much difference, except one comes with interest charges.

Here are a few situations where an RRSP loan looks more attractive:

You're in a very high tax bracket

The higher the tax bracket, the bigger your refund. That's a powerful motivator. Just make sure to put your refund to good use and not for conspicuous consumption.

It won't eat up all your cashflow

If you can easily afford the monthly payments without straining your budget, that leaves you flexible in case you have unexpected expenses. If you can also afford to make contributions to your RRSP in the current year in addition to the loan payments, that's a good sign. It means you won't need an RRSP loan next year.

You're only using a short loan

You should be able to pay off the loan quickly, ideally in less than six months. That minimizes the interest you'll have to pay.

It can make sense to take out an RRSP loan if you've never saved before and have had trouble establishing a savings habit. Some people might start the year thinking they will save a certain amount to their RRSP and miss their target because they stopped saving. Committing to a one year RRSP loan is more likely to result in hitting your savings target for fear of missing a loan payment. But if you can make a year's worth of RRSP loan payments, you should be able to set up a regular savings plan, too.

Featured Download: Understanding RSPs & TFSAs.

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