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When is $20,000 in Debt Better than $8,000 in Debt?

Because I’ve never been in a position where an RRSP loan made a lot of sense I never considered all that many financial strategies that were associated with them.  This led to a bit of a surprise last week when one my friends (we’ll call him “John” to keep it anonymous) called and asked for my opinion on a somewhat unique financial move he had read about (after learning about online lending from our Borrowell Review) and was thinking would work out well for him.

Before we get to John’s RRSP loan strategy, I’ll give you a bit of background on his situation.  He readily admits that he wishes he had pay more attention to his finances a little earlier in life, but as a kid his parents didn’t have a lot of money and they absolutely never talked about how to manage any.  Coming out of high school, because his parents’ income was quite low, he was able to receive large student loans – which he took advantage of like most 18-year olds out there.  After four years of post-secondary John had developed some really bad spending habits.  He worked hard in the summers and made a lot more than the average student did, but he also spent a ton of money.

He graduated with slightly higher-than-average student debt and a few thousand dollars’ worth of credit card debt.  He didn’t expect this to be a problem since he had graduated from a unique program that allowed him to attain both a university degree and a college diploma in that four year span – and he naturally believed this would allow him to land a great job.  The problem was that the field he had chosen – journalism – had some really terrible job prospects (and still does today).  John knew he had to pay his dues and get some hard-fought experience within the industry, so he took every minimum wage job he could find in media and worked multiple serving jobs on the side to pay the bills.  Of course because he still hadn’t learned anything about money, and had those negative spending habits to contend with, he continued to pile on credit card debt.  This sort of spiral continued for a couple of years.

They All Lived Happily Ever-After

High FeesThankfully, this story has a happy ending.  John caught on to a great job with a provincial government (after several months of total unemployment) where he could put his media skills to use “from the other side of the fence”.  He is now 29-years old and is making roughly 70K a year.  A couple years ago when John landed his current job and felt like he finally had his head above water he began to talk to me about his financial situation and ask for help a little at a time.  We talked about some budgeting basics and consolidating the staggering amount of credit card debt he had accumulated into a low-interest loan.  Even after that step, he still owed over 20K on a LOC locked in at 11% (due to his bad credit rating this is the best loan he could secure) and a decent-sized student loan.

Pre-Tax Investing With an RRSP Loan

Two years later John is in much better financial shape.  While he knows he could definitely cut more spending from his budget, he has developed solid savings habits and he is considering learning more about investing and possibly even buying a house.  So when he asked me what I thought about the strategy of using an RRSP loan I wasn’t quite sure where he was going.  In a nutshell this is the calculations he had looked at:

1) John still had about $8,000 left on his LOC.

2) His combined federal and provincial tax marginal tax rates was 39.4%, and the RRSP loan he was considering taking out would generate a rebate average of 35.5% of his income (in other words he was going to pay some serious taxes).

3) He had very few deductions this year as a single male with no dependents, no education costs etc.

4) The bank would give him a $20,000 RRSP loan at prime + .25% (locked in as opposed to floating)

5) That loan would generate a rebate for him of about $7,100.

6) He would not even look at the rebate cheque and would instead immediately pay off his LOC (using the cheque plus a few hundred dollars of savings).

7) This would leave him with a 20K loan instead of an 8K loan, but also 20K worth of assets in his RRSP and a much better interest rate on his debt.

8) In a few years (probably five) he would like to take advantage of the Home Buyers’ Plan to borrow from his RRSP in order to make a down payment on a house.

9) While John was interested in equities, I explained that personally, my theory was that if he wanted the money in the next five years, he ultimately should not have a lot of exposure to equities.  After a couple of conversations he decided to put the money in a 5-year GIC at his bank (I explained what bond ETFs were, but he wanted to keep it simple) at 2.7%.

10) John realizes that the interest he is gaining on his investments will be less money than he is paying on interest charges on his loan, but that it’s a pretty slim margin.

When is $20,000 in Debt Better than $8,000 in Debt?

Ultimately, I thought it was slightly unorthodox to view going from 8K in debt to 20K in debt to being a smart borrowing decision, but I have to agree that given the circumstances I think it is a great deal.  Also, one can’t discount the importance of the huge morale boost paying off that LOC gave John, as well as the feeling of empowerment he now feels when he views his finances.  He has made some hard savings goals and intends to pay off his RRSP loan and student loan in the next two years as he learns a little more about long-term investing.  John also knows how vitally important it is he not spend any of his RRSP refund, and instead “invest” it all at an instant guaranteed ROI of 11% by paying down that LOC.  I’m glad to say that I believe he is now on the road to financial success.

Has anyone else every used a RRSP loan in this manner?  I’ve always had substantial tax credits and it hasn’t made much sense for me at all to even consider.  I think this is one of the few occasions where it could save someone a lot of money in the long-term though.

Article comments

Anon says:

10 year open RRSP loan is readily available for good credit score consumers.

This is a great strategy

Scott says:

I have recommended this strategy a few times to clients over the years. I obtained a new client this year by recommending a $20k+ RRSP loan (prime+0.5%, 39% refund) to pay-off $8k credit card balance (19.9% interest). This was a woman in her 40s, making (and spending) $150K+/year. She had no previous RRSP contribution. We sat down, worked on a budget including an 18 month loan repayment schedule and closed her credit card account. I’d like to think she’s better off now than before, but since I’m an evil Investors Group consultant I’m sure TeacherMan will explain why she would have been better off not meeting me and continuing to only make minimum credit card monthly payments.

Teacher Man says:

Not an intrinsically evil person Scott, merely working in an industry that provides the wrong incentives in terms of compensation. I’m glad to hear you are saving your clients money, we just simply disagree on if (in the average situation) an advisor will save a client enough money to offset the relatively large amount of investment returns they are sacrificing by investing through high MER mutual funds. Since we’ve been over this debate again and again on the other thread, I guess we’ll just have to agree to disagree on that point and there really isn’t a way to fully quantify it since the value of your advice will be so radically different in each specific case.

Koala says:

I would be pretty hesitant about doing this myself. Is the loan really locked in? How long will it take to pay off and is prime likely to change much in that period?

Also, when it comes to the HBP I think many people are claiming deductions when their salary is lower and then paying back the money when their salary and tax rate is higher.

I don’t know the tax brackets involved, but I would only claim enough of a deduction to move down one bracket.

Teacher Man says:

The loan is definitely locked in (I made sure to ask). He estimates 3-4 years to pay the loan off (who knows when prime will change – if anyone knew for sure they’d be an automatic millionaire).

LPC says:

How long is the RRSP loan for? Aren’t they usually just for one year?

If I understand correctly, he reimbursed his LOC with his tax refund by borrowing $20K for an RRSP. From my point of view, he took advantage of the tax break this year and paid off a debt, but it’s just a delaying tactic. Now he’s $20K in debt, with no room to make contributions and take advantage of next year’s tax breaks. I think it would have been easier to just pay back the $8K today and start saving once it’s paid off.

Teacher Man says:

Not quite LPC, the RRSP loan has no time limit (this one specifically, I’m not sure about in general). He did reimburse the LOC he had before, but sense it was at a much higher interest rate, there is a massive difference there.