Good Debt vs Bad Debt or Why You Need a RRSP LoanPosted: January 8, 2014
For most Canadians, saving money can be an issue, let alone eliminating bad debts. But for many, borrowing money for the right reasons can lead to increased personal savings. We like to categorize loans into three types…Bad Debt, Not So Bad Debt and Good Debt.
Bad debts are the loans at high rates (anything over 7%) and are usually easy to get and hard to pay off. Credit cards, overdraft accounts (not line of credit accounts which are different), store credit with no payments for a year, payroll loans, etc. Next time you see one of those payroll advance adds on TV, pause the screen when the fine print comes on and read it. To make it easy for you, a $20 fee for a $200 loan for one week works out to approximately 520% per year as an interest rate. Definitely very bad debt.
Not So Bad Debt:
Also known as life style requirement loans based on your personality. Car loans and leases fall into this category. We can all get along with a used Civic, but for just $200 bi-weekly, just think of the car you could have! OK, auto loans should be in the bad debt category, after all, cars are a depreciating asset, but we have to justify the new car urge every three to four years somehow. Plus in our case, it’s a tax write off. Not so bad debt it is!
Also in this category, and you may be surprised by this, family loans. Yes, often at zero percent from Mum and Dad but at great cost to relationships and the unwanted advice that may be attached to these loans. Avoid if at all possible.
There are two types of good debt; mortgages and RRSP loans. We’re Mortgage Brokers by trade, so our belief in mortgage debt as a good thing goes without saying. Based on historical data, over the course of your lifetime you should be able to bank on a return of 5% per year on real estate holdings if kept over the long term. The fact that you can leverage this investment and live in it vs paying rent and someone else’s mortgage payment, makes it a no brainer. The majority of our clients who retire financially comfortable are there because they have paid off their house. Reverse mortgages are also good debt but that’s for another story.
This brings us to RRSP loans, and why you may want to consider this as a form of savings. If we asked the majority of our clients to place $400 to $500 per month in a savings account, most would not be able to keep it up over the long term. Something always comes up to distract us from our savings. Auto repairs (another reason new vehicle loans should be in the not so bad debt category….warranty!), home repairs and upgrades, tuition payments, broken appliances, holidays, etc. Life is just like that. But, if the majority of our clients took out a loan for an RRSP with a $400 per month payment, they would never miss that payment or even be late on a payment. And what is the big motivation for doing an RRSP? Because the entire amount of the RRSP is a tax deduction in the year you make the investment. And you have until March 3, 2014 to make your contribution for 2013.
We’ll quickly break it down for you. Your RRSP carry over is the amount shown on your tax assessment each year. For most Canadians, the carry over is in excess of $100,000! This is the amount that you are eligible to write off against your income for the year you make the contribution. You don’t have to use the entire amount. You can take as much of it as you wish. This is where you can maximize your tax refund by borrowing the money for your RRSP from a bank or credit union to make the contribution worth while. Lenders love these loans, and many will look at rates as low as prime (currently at 3.5%) to prime plus 2 or 3%. Many lenders will also allow up to 10 years to pay it back, so the payments are reasonable. Good debt, that’s for sure! Let’s look at an example:
We’ll keep it simple and look at it as if you are in a 33% tax bracket. This makes for easy calculations. We will also factor payments, for example only, on loans over a ten year period at roughly prime rate. This means approximate payments of $100 per month for every $10,000 you borrow. Now it’s easy to approximate your individual situation, but keep in mind this is for example only! We can and are happy to assist you in exact numbers if you drop us a line asking for more info. Now, back to the example:
A $30,000 loan equals $300 per month. This will give you a $10,000 tax refund, which you can do whatever you want with. Pay off credit cards, go on holiday, pay down the $30,000 loan to $20,000. Whatever you like. No strings attached. You invest the money you borrowed usually with the bank or credit union who lent you the money. Place it in a term deposit (zero risk) or in mutual funds (much greater risk). Let’s say you go with the term deposit route. In ten years you have paid off the loan, and at a 2% interest rate on your term deposit, you now have around $36,000 in the bank plus you got the $10,000 refund from the government. You’re $46,000 ahead, and if you used the tax refund to pay off lingering credit card debt, your most likely double that amount! Amazing, better than if you saved $300 a month! Except this way, you’re sure to do it. Oh, and the interest on your investment is tax free in an RRSP account.
If you are interested in more information regarding RRSP loans and investments, please drop us a line. We are not investment advisers as such, and do not receive payment for or assist in obtaining RRSP loans. We do, however, have excellent connections with lenders who can provide these services for you, and are happy to assist in referring you to one in your neighborhood. We can, however, assist with term deposits, and offer some of the best rates in the country through our lender channels. As we said earlier, feel free to drop us a line if you require more information. We look forward to hearing from you.