The deadline for making a 2011 RRSP contribution is February 29, 2012.
Making that contribution can save you anywhere from hundreds in taxes to over $10,000 depending on your province and tax bracket. Plus, you’ll enjoy the tax-deferred long-term growth of that investment while it sits in your RRSP.
The challenge for some, however, is not having enough money to make an RRSP contribution. According to Investors Group, 58% of those not investing in an RRSP say it’s because they don’t have the funds.
One possible solution if you’re cash strapped is an RRSP loan. Another is a cash back mortgage. We examine the pros and cons of each here…
Cash Back mortgages give you anywhere from 1-7% of your mortgage in cash on closing. You can take that cash and immediately make an RRSP contribution with it.
RRSP loans are a little different. They’re basically just straight loans secured against your investments instead of your house.
Each has its relative benefits…
Cash Back Mortgage Advantages
- Monthly payments are typically lower on the funds borrowed for your RRSP contribution (That’s because the amortization period of a mortgage is usually longer than an RRSP loan.)
- Most, but not all, mortgages compound semi-annually. RRSP loans often compound monthly, which is slightly more costly (Albeit, the difference is far from enormous.)
RRSP Loan Advantages
- You can sometimes borrow more for your RRSP with an RRSP loan than with a cash back mortgage, depending on the mortgage amount and lender.
- Unlike a cash back mortgage, there is no clawback of cash to worry about (If you break a cash back mortgage early, you typically must pay back a pro rata portion of the cash you received. Beware that some lenders make you pay it all back, even if you’re just a few days until maturity.)
Another key differentiator between these two options is the interest rate.
Rates on RRSP loans currently range from roughly 3-7% depending on institution, loan size, qualifications, term, etc. That means you’ll pay roughly $200-$550 interest per year for every $10,000 borrowed.
Cash back interest rates are usually 0.40% to 2.00% more than a regular fixed mortgage. That translates to about 3.60% to 5.29% today. The actual rate depends on the mortgage term, lender and cash back amount, among other things.
Despite the higher-than-normal mortgage rate, people often forget that the effective rate of a cash back mortgage is substantially lower. That’s because the lender is handing you cash up front, which reduces your overall borrowing cost.
In fact, for large mortgage amounts and shorter terms, you’ll occasionally find effective rates that are actually lower than a regular mortgage.
Once you solidify your interest rate, you’ll need to determine your payback period. In other words, how long will it take you to repay the money borrowed for your RRSP contribution?
Key Point: RRSP loans are meant to be short-term. That can’t be stressed enough. Otherwise, the borrowing costs eat up the gains.
Even if you’ve used a cash back mortgage and amortized your RRSP contribution over 25 years, you absolutely and unequivocally need the discipline to pay back the RRSP portion quickly (usually within 1-3 years, depending on the rate, RRSP return, amount of tax refund, etc.).
With the interest rate and payback period determined, you can then compare the interest cost to your gain. That gain includes both the RRSP tax deduction and your projected investment growth. This, in part, will confirm if borrowing for your RRSP is worth it.
Assuming you do borrow to contribute, you can generally expect a tax refund. Use that refund wisely. Financial advisers often recommend one of three things:
- Prepaying your RRSP loan with it (Doing so lowers your interest expense, which is not tax deductible)
- Using it to pay off high-interest debt
- Using it to make an RRSP contribution for the current year
Before we wrap things up, it’s worth mentioning one other alternative to a cash back mortgage: a regular refinance.
Rates on a regular refinance are generally (but not always) less than the effective rate of a cash back mortgage. But a refinance comes with issues of its own.
- Need enough home equity to refinance.
- Face default insurance premiums if your loan-to-value (LTV) is over 80% (85% LTV is the limit if you want the best rates.)
- Pay a penalty if you have to break a closed mortgage early. (Mortgage penalties often ruin the math and make borrowing for an RRSP contribution uneconomical via a mortgage.)
- Pay legal fees to refinance. (By comparison, legals are often paid by the lender when you “switch” into a cashback mortgage at maturity. Lenders occasionally cover legals on regular refinances as well. (Just watch out that they don’t charge you an offsetting rate premium in return.)
Whether RRSP borrowing (of any kind) is right for you depends on your tax bracket, contribution room, ability to handle more debt (even if short term), risk tolerance, time till retirement, and likely payback period, among other things. An independent financial advisor or accountant are good sources to help you sort it out.
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Rob McLister, CMT