RRSP Loan Strategy: Pay off high interest debt with a big RRSP contribution

Another RRSP loan strategy that some people use who are behind on their RRSP contributions is to take a really big RRSP loan all at once and to use the big tax refund to reduce high interest debt.

One of the reasons they would carry high interest debt is due to poor budgeting and you have to careful before contemplating a strategy like this that the "budgeting" problem has been fixed, but nonetheless I have seen many couples who have reached a fork in the road.  They have either overspent so much that they have maxed a bunch of credit cards and department store cards and can’t get anymore. They realize that they are in trouble, and the only reason they don’t continue to overspend is that all their money goes into maintaining the payments on their mortgage and other debts.

When this strategy is really good to look at is when you are trying to get back on track by making big monthly payments on your high-interest debt because you realize just how much money is being paid in interest carrying costs and you have decided to fix the problem once and for all.  You want to reduce your bad debts and put the interest savings perhaps into retirement savings. Great. But you feel like it’s going to take an eternity to make headway, right? Well here is how this strategy might work for you…

Let’s take a sample couple named Joe and Jane Timeforachange. They overspent their way to a bunch of maxed out credit and department store cards that looks like the following:

           Description     Interest Rate     Balance Owing     Monthly Payment

MasterCard            19%                $3,000                  $100

VISA                       19%                $7,000                  $100

Department Card     29%               $3,000                  $200

Department Card     29%               $2,000                  $200

In this case we have a total of $15,000 in high-interest debt and Monthly payments of $600 in total. The total amount of interest being charged PER MONTH is $279.16. Calculating the interest you are being charged to carry debts on assets that have long depreciated is a humbling experience. In this case, almost half of the payments are being directed to interest costs alone!

Let’s assume that Joe and Jane are a single income family and Jane is the bread-winner – she earns $145,000 per year and Joe is a stay at home dad. This would put Jane in the highest tax bracket, which for Ontario is 46.41%. Since this couple has been playing catch-up with their finances, they have really fallen behind in their retirement savings so there is a LOT of unused RRSP contribution room (sound familiar? Only about 10% of Canadians maximize their RRSPs).

If Jane could make an RRSP contribution big enough, the tax refund could be large enough to completely wipe out her high-interest debts! So what would be involved?

Well, we know that they don’t have the cash on hand (otherwise they would’ve paid off their high-interest debt long ago!) so they will need an RRSP Loan. They have to calculate how much of a loan they will need in order to generate a tax refund equal to $15,000. Most people at this point would just take the $15,000 and divide by 46.41% to arrive at $32,320. But I would caution you that you need to see if you drop through any tax brackets because that will affect your refund.

An easier way to figure it out is to log onto Ernst & Young’s Personal Tax Calculators and specifically the RRSP Refund Calculator.  It will give you a very good idea as to how much you will need to borrow and contribute to your RRSP to get a certain amount of refund – just plug in the numbers until you get the desired refund.  For Jane, we arrive at the following amount of contribution needed for a $15,000 refund: $32,887. In this case, the number from the calculator was pretty close to the rough calculation we made, but for incomes that are closer to the threshold’s for lower tax brackets, the difference can be SIGNIFICANT.

The next thing to do would be to get the RRSP loan! Ideally, what you want to do is keep your cash flow the same as before the loan, so you would like to find how long the loan should be for a $600 monthly payment.

Using a loan calculator we find that $32,887 paid back over 60 months (and assuming an interest rate of 7%) would be about $650 per month. That’s close enough that it makes sense for our couple. Now, before getting the loan, you will want to look for a loan provider that allows for a 3 or 6 month deferral on your first payment.  The reason for this is that once you take out the loan and make your RRSP contribution you will have to pay for not only the loan ($650/month) but also the debt payments ($600/month) until your tax refund arrives! By having the ability to defer the first loan payment for 3 or 6 months you can eliminate the overlapping payments.

So, let’s look at the situation they would be in assuming NO RRSP Loan, and that when they pay off their debts, they start contributing to their RRSP with the freed up money. We will assume in all cases that the RRSP investments yield an 8% average rate of return:

                       Debt          RRSP Value        NET          Cash flow 

Now                 ($15,000)        $0              ($15,000)    ($600)

3 years later     $0                   $0              $0              ($600)

5 years later     $0                   $15,610      $15,610      ($600)

Compare this to what their situation would
look like if they used this RRSP Loan Strategy: 

                       Debt          RRSP Value        NET          Cash flow 

Now                 ($32,887)     $32,887          $0             ($600)

3 years later     ($14,525)     $41,428          $26,903     ($650)

5 years later     $0               $48,322          $48,322      ($650)

If we really wanted to compare apples to apples, we would have the couple take out an RRSP catch-up loan in the BEFORE strategy as soon as they pay off their debts. Additionally, we would immediately take their $15,000 refund at the end of year 3 to pay down the RRSP loan. This means they will have an RRSP loan balance of $17,887 starting in year 3. In which case it would look like the following:

                       Debt          RRSP Value        NET          Cash flow 

Now                 ($15,000)        $0              ($15,000)    ($600)

3 years later     ($17,887)        $32,887       $15,000     ($600)

5 years later     ($4,453)         $38,359       $34,404      ($600)

Hopefully by now you can see that the strategy does work by putting in a lump sum into the retirement savings now and by basically converting bad debt to good debt. But probably the best part of the strategy is the psychological lift you can get by not swimming in debt with high-interest credit cards and department store cards and having a substantial amount of savings to kick-start your RRSP.

Some critics will no doubt argue that anyone expecting an 8% rate of return would not expect a STATIC 8% return every year and the performance over the short term could be net negative. It is a valid point and you should consider what effect that would have both financially and psychologically by consulting a professional. It should be noted that if you buy fixed income investments inside your RRSP, while yielding less than 8% long term, the strategy would still make sense. Do the math for yourself – it is a good exercise and good practice to see the effects of different strategies with different rates of return… 

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