Wednesday, January 24th, 2018
A: In a previous post, I put RSP loans in the list of "not-so-good" things about RSPs. So when a reader named Heidi emailed asking if I could explain when it might make sense for her (or anyone) to take out an RSP loan, I thought I should expand a bit more on the topic. First, let's look at some background.
An RSP loan is just that – a loan from a financial institution that you use to make an RSP contribution. These loans are usually meant to help you "catch up" on your unused contribution room, since unused contribution room carries forward indefinitely and can become quite substantial if you don't regularly contribute to your RSP(s).
The benefit of an RSP loan is this: It allows you to make an RSP contribution, which in turn will likely generate a tax refund. So that's actually two things: more money in your RSPs to grow and a tax refund that you can use immediately as you see fit. That sounds pretty cool actually, right?
Here's an example showing when it might make sense to take out an RSP loan:
Say you've made RSP contributions throughout the year of $7,000. Let's also say you're in a 30% tax bracket. So that means that in theory, you're going to get back 30% of what you contribute, since RSP contributions reduce your taxable income by the amount of the contribution. So you're currently looking at a $2,100 tax refund. If you took out an RSP loan for $3,000 to top your total RSP contributions for the year up to $10,000, you're going to get back a $3,000 refund, which you could use to immediately pay off the balance of the loan.
So by taking out the RSP loan, you've just added $3,000 to your RSPs, and it basically cost you nothing because you paid it back as soon as you got your tax refund. It's important to note, however, that it did kind of cost you something – you spent your whole tax refund repaying the loan, so if you had other plans for it, you'll need to de-prioritize those.
The drawback of an RSP loan is this: You're taking out a loan.
And unless you're going to prioritize paying it back as quickly as possible, it might not be the best idea to get one.
Here's an example showing when it probably doesn't make sense to take out an RSP loan:
You haven't made any RSP contributions all year, so to play catch-up, you take out a $10,000 RSP loan. You're in a 30% tax bracket, so the loan will generate a $3,000 tax refund. You immediately apply the $3,000 refund to your outstanding loan balance. But you're still left with $7,000 to pay back, plus interest. If you pay that back within the year (the smartest thing to do if you do take out an RSP loan), then you're looking at around $700-$800 in monthly payments.
I end up spending a lot of time talking with people about their finances. And here's the thing – I know hardly anyone who would say they easily have an extra $700 or $800 a month, unaccounted for. Now, yes, that monthly payment could be much reduced if you extended the length of the loan repayment (bad idea). With some institutions, you can repay the loan in periods of up to 10 years. Yikes!
If you're someone who struggles with saving regularly and you tend to spend whatever money flows into your chequing account, then I think an RSP loan could make a lot of sense. Because a forced repayment schedule of that loan will reduce the amount of unnecessary spending you're able to do over the course of that year. And getting used to regular savings into your RSP (or in this case, the repayment of money already in your RSP) is very smart behaviour. So once you've paid that loan off, it should be easy for you to continue contributing that same amount into that same RSP. If you use a one-time RSP loan to build smart saving behaviour, I'm all for it.
Bottom line: Trying to max out your RSP(s) is a great idea, but not at the expense of a loan if you'll be struggling to pay it off. You're better off getting into the habit of setting up regular contributions to your RSP than you will be trying to play catch up with an RSP loan. Consistent, automatic savings plans are one of the keys to investing success. Probably the best person to tell you if you should take out an RSP loan is your accountant, not your financial advisor.
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This article is intended to provide general information only about RSP loans. If you need further information about your specific circumstances you should speak to an investment advisor.