An RRSP loan is a lending solution providing financing to help you optimize your RRSP contributions. RRSP contributions are subject to tax deductions so that you can benefit from tax refunds at your marginal tax rate.
Just like other loans, RRSP loans involve interest applied to the borrowed amount, either at a fixed or variable rate. Still, you can pay off your loan quicker by applying the tax refund towards your outstanding balance.
Pros and cons
Before applying for an RRSP loan, you need to be aware of its benefits and potential drawbacks. For select categories of borrowers, this type of loan can be a financially beneficial solution. For others, it won’t make good financial sense.
Pros
The first and foremost benefit of an RRSP loan is a potential tax refund. The sum you contribute to your RRSP is not subject to income tax. You can further use this tax refund toward your debt repayment. An income tax deferral from your RRSP contributions is especially beneficial during high-income times when your tax bracket is higher. By retirement, when you finally withdraw your RRSP savings, your tax bracket may be potentially lower.
Second, with an attractive return rate, the compound growth of your RRSP investments may exceed the interest you will have to pay.
Third, you can get the advantage of deferred repayment offered by most lenders and postpone your first payment for up to 90 days.
Fourth, RRSP loans typically involve flexible limits and terms. That is, you can borrow from $1,000 to $50,000 and either contribute to the current year's contribution room or catch up on a missed contribution room from previous years. The repayment terms can range from one to five years.
Finally, RRSP loans don't involve prepayment charges, so you can make lump sum payments or pay off your debt in full at any time, penalty-free.
Cons
Still, in certain circumstances, it doesn't make financial sense to borrow money to contribute to your RRSP.
First, if your marginal tax rate is not that high, your savings from borrowing funds to contribute to your RRSP might not be that attractive.
Second, the return on your RRSP investments should be high enough to cover the interest paid over the loan term. Otherwise, borrowing may not be worthwhile, especially if the interest rate for an RRSP loan is initially high.
Third, an RRSP loan assumes that you borrow to invest. If you already have other outstanding debt, it is worth focusing on repaying it first before signing up for a new loan amount. Otherwise, your monthly cash flow may suffer.
How does an RRSP loan work in Canada?
With a Registered Retirement Savings Plan or RRSP, you can deposit funds up to an allowed contribution limit, thereby saving for your retirement and growing your money on a tax-advantaged basis. Along with cash deposits, you can hold investment vehicles like savings accounts, term deposits, and mutual funds in your RRSP. Until withdrawn, the funds held in your RRSP are growing tax-free. The contributions you make are tax-deductible.
While making regular RRSP contributions is a wise financial strategy, you need spare cash to implement it. This is where an RRSP loan comes in handy.
With an RRSP loan, you can get the necessary funds to either use the current year's contribution room or catch up on a missed contribution room from the past year. As long as you can get a tax refund, you can pay off part of your loan and become debt-free faster.
How can I get an RRSP loan in Canada?
Many financial institutions across Canada offer RRSP loans to help you invest in your RRSP. You can find such loans at the big six banks like Royal Bank of Canada, BMO, CIBC, TD Bank, Scotiabank, and National Bank of Canada, as well as smaller banks and credit unions.
Although eligibility requirements for RRSP loans differ across lenders, we can outline the common criteria you should meet to get the desired financing. To qualify for an RRSP loan, you must be a Canadian resident of the age of majority in your province or territory. When reviewing your loan application, a lender will look at your gross annual income, financial obligations, and credit score. A credit score of 660 or higher increases your chances of getting credit approval. Meeting the eligibility requirements is the key to getting approved quickly.
To apply for an RRSP loan, you must visit a financial institution in person and talk to their representative. Select lenders accept applications for an RRSP loan online.
How can I withdraw money from my RRSP?
Now, let’s see how RRSP withdrawals work. As you probably know, your RRSP matures by the end of the year when you turn 71. You can withdraw funds from it at any time before that time, but early withdrawal tax may apply. Still, penalty-free early withdrawals are available in two cases - buying your first home and paying for your education.
If you qualify for the Home Buyers’ Plan, you can withdraw up to $35,000 without paying taxes and put it toward a down payment on your first home. After that, you will have 15 years to re-contribute the withdrawn amount back to your RRSP.
If you qualify for the Lifelong Learning Plan or LLP, you can withdraw up to $10,000 tax-free annually, to a total of $20,000, and pay with these funds for education or training for you, your spouse, or your common-law partner. Within ten years, you can re-contribute the withdrawn amount back to your RRSP.
Applicable taxes
The amount of withholding tax applied to early RRSP withdrawals may vary based on the province and the amount withdrawn. That is, for withdrawals of up to $5,000, your withholding tax rate will be 5% in Quebec and 10% in the rest of the country. For withdrawals between $5,000 and $10,000, the tax rate will be 10% in Quebec and 20% in other provinces. Withdrawals of over $15,000 involve a 15% withholding tax in Quebec and 30% — in the rest of the country.
Tax refund
The full amount withdrawn from your RRSP counts as taxable income on your tax return. Whenever your current income exceeds your retirement income, you will have to pay a higher tax bill.
Along with that, the withdrawal you make means losing this RRSP contribution room and an opportunity to save money on a tax-sheltered basis. There is no option to compensate the amount of a withdrawal to a used contribution room in the future. Losing out the power of tax-deferred compounding is also frustrating, and recovering takes quite a long time.
What is the interest rate on an RRSP loan?
Being traditionally lower than personal loan rates, interest rates for RRSP loans differ across lenders. Banks like the Royal Bank of Canada set RRSP loan rates as low as the Prime Rate. The National Bank of Canada sets fixed RRSP loan rates in a range between 5.25% to 6.75% and variable rates — between the Prime Rate plus 0.75% and the Prime Rate plus 2.25% depending on the term. The Prime Rate means the annual variable interest rate posted by the financial institution.
With an RRSP loan calculator, you can get an idea of the expected tax refund and total interest cost of your loan. Here is an example for illustration purposes. Let’s assume you are borrowing $2,500 to take advantage of unused RRSP contribution room from the previous years for a two-year term at a 5.95% interest rate with a monthly payment frequency. Your marginal tax rate is 40%, and you are going to apply 100% of your tax return toward the loan balance; the estimated annual RRSP rate of return is 4.00%, and you have 10 years left before retirement. By plugging these loan details into an RRSP loan calculator, you will see that the expected tax return on a $2,500 RRSP contribution will constitute $1,000. Given that you contribute your tax rebate toward the loan balance, the adjusted loan amortization term will be one year and three months; your monthly RRSP loan payments will be $110.74, and you will pay interest of $77.64 throughout a two-year loan term. Based on the estimated annual RRSP rate of return of 4.00%, the RRSP value at the time of the loan repayment will be $2,625.62. By the time you retire, the expected RRSP value will be $3,700.61.
