RRSP Loans: is borrowing to invest worth it?

Welcome back to Drawbridge
Finance. today we’re talking about RRSP loans. Hey Everyone welcome back my name is
Levi woods. I’m not a professional investor, I don’t work in the financial
industry and this is an opinion channel about money. Today, I want to talk to about RSP loans and this is a pretty touchy subject because basically the theory behind RRSP loans is that you borrow money and then invest it. Now you can invest in a guaranteed investments certificate and make a guaranteed return. Usually that return is less than the amount
of interest that you’re paying on the loan so it’s a it’s difficult to get those guaranteed investments to pay more than the interest. It doesn’t
usually work out so what most people do is they invest in the stock market or
they invest in an ETF that’s going to potentially return an average rate of
return that’s greater than the amount of the cost of the loan. If we could
get a loan for four and a half or four and three-quarters percent but we
know that the S&P 500 returns around seven point eight percent on average per
year then in theory the the loan will cost us less than the returning the
investment now RRSP loans are interesting RRSP Loans are available to Canadians
and what they do is they allow the borrower to borrow money to invest
specifically into their RRSP before the RRSP deadline of the end of February. What this does is it increases the amount of refund that they get when they do
their income tax. Now RRSPs are not the best financial vehicle
because we eventually have to pay that tax in the future so it’s something to
take into consideration what the marginal tax rate actually is and I’ll
cover that in this video but what what it allows people to do is start
investing without actually having any money right now today for for myself I
actually did this I have taken two RSP loans in my life because when I was
young I knew that I needed to start investing they were not well kind
because I was invested in the broad market we know that we had the dot-com
crash in the 2000s 1999 mm and I lost a substantial amount of
that money that I had borrowed to invest so I know firsthand that this is is a
risky thing to do but what that did was it set me on a path that I continued for
the rest of my investing career because I knew that from that day when I was 18
years old I knew that I had to make a payment basically into my future self so
that my investment could grow over time and by having that loan it it created a
pattern which I still follow today so something that I did when I was 18 I’m
now doing one in 39 so 21 years I’ve been contributing to this investment
plan and that’s why I’m able to be able to be retired later this year so let
what I want to do today is I want to do some fictional character analysis and
we’re going to compare two people that are both eighteen years old they both
work minimum wage kind of part-time during the school year and then
full-time during the summer months and so they have an average income of
$15,000 per year their current investment value is $0 and we’re the
reason that I’m using the small figures because I’m going to look at the
marginal tax rate for these characters both of them are their friends and they
decide that they’re going to that in 2019 is the year that they need to start
investing and they both want to contribute 16.7 percent of their income
so 16.7 percent of their income works out to $2,500 and they and that seems
like a reasonable goal so both of them make an agreement to each other they say
okay next month in March we’re gonna start – each of us are going to take
$250 put it into our RSP and at the end of the year ten months from now we will
have contributed $2,500 each first we’ll look at Bob scenario RSP contribution
for Bob is really really simple he’s gonna go to the bank he’s gonna open up
an RSP account he’s going to set up an automatic contribution of $250 so in
march march 1st to 5th new dollars beginning is gonna get transferred from
his savings account to his RSP account and then that money is going to start
theoretically growing at we’re gonna say a 7 percent rate of return because I
shown many times how easy it is to get a 7%
rate of return if you’re interested in that there’s a video link right up here
you can click on that you can see how to make a 7% return very easy chart he puts
in 250 dollars it makes a little bit of money makes a dollar 46 in the first
month so his total value at the end of March is going to be 250 $1.46 in theory
now in April first he puts in 250 dollars so now at the end of April his
total value a little bit of interest and we’re basically at 504 dollars carry on
through the year at the end of the year he’s contributed $2,500 his investment
is worth twenty-five hundred and eighty one dollars so he’s made a total profit
of 8163 and this is average and theoretical so you know take that into
account when you’re looking at any of these spreadsheets now Alice what she’s
gonna do is she’s going to say you know I I can be smarter about this I can put
the whole twenty five hundred dollars in right now and I can get a larger refund
from my tax return that is deferred taxes that and then it can pay it later
in my life when I when I have more money so she does a quick search on the
internet and she comes up with an RSP loan calculator I’ll leave a link down
in the description below for the websites that I’m using today she wants
to borrow twenty five hundred that’s her goal twenty-five hundred dollars
is this a top up loan no this is brand new the loan repayment period we’re
gonna say one year because she wants to pay back within the same year that Bob
does the payment frequency she’s gonna make a monthly payment now the interest
rates this this is gonna vary depending on your situation but I’m gonna put in a
four point seven five percent interest rate and then do you want to defer the
start of your loan repayment by up to 90 days saying no because in this case
alice is going to start contributing next month in March anyway so she’s
gonna make her very first loan payment of $250 that’s how much she’s going to
invest the same is Bob on March 1st so we’re not gonna defer the payment and
then we’re gonna click continue so tax information once your marginal tax rate
now in order to figure that out there’s that here’s another website that I found
I’ve typed in the income 15,000 click to calculate a marginal tax rate for
British Columbia and living on 15 a year is around 20% it’s super easy
calculation there’s many websites out there to tell you what your marginal tax
rate is based on what your income is we’ll go back to the loan and we know
the marginal tax rate is 20 percent so we’ll type that in 20 percent and then
the percentage of tax refund to apply to the loan balance now this is the the
most important part about this type of strategy because you’re making this
investment in the RSP then you’re a refund from your income tax is going to
be greater so the worst thing that anyone could do is go on just spend tax
refund because they’ve borrowed money to to invest and then they’re getting more
money back from their refund if they spend it that money is just gone so what
needs to happen is they need to take that refund and apply it to this loan so
we’re gonna say a hundred percent of the the return that we’re getting is going
to go to back to the loan now we know that if the marginal tax rate is 20
percent when you best twenty five hundred dollars twenty percent of twenty
five hundred dollars is going to be five hundred dollars so our income tax refund
is going to be increased by five hundred dollars more than if we had made this
RSP contribution so that five hundred dollars is going to go back to the RSP
loan and you’ll see that in the chart when we fill this out so we’re gonna
click continue estimated annual rate of return RBC
wants to say SEC six percent I’m gonna put in seven percent here it doesn’t
really matter we’ll look at that even if it’s a zero percent we’ll look at how
the benefits or non benefits of this work out in the end so the number of
years to retirement now both these characters are 18 years old so we’re
gonna say they’re gonna retire at 65 so forty seven years and click continue you
have to remember this is from a $2,500 investment if you’re twenty five hundred
all investment in one year if you hold it for forty seven years at a seven
percent rate of return your RSP is gonna work worth sixty thousand dollars
twenty-five hundred becomes sixty thousand dollars this is the power of
compound interest the expected tax refund and twenty five hundred dollars
we knew that it was going to be five hundred because we can do that Mathis
twenty percent which is what the marginal tax rate is if your marginal
tax rate is lower then you’re gonna get less money back if your marginal tax
rate is higher you’ll get more money back so the amount of tax refund to
apply to the law five hundred dollars that’s the super important part the
payment that Alice has to make is actually only two hundred and $13.73 now
we said at the beginning of the video both of them are gonna invest $250 so
she sets up this automatic loan payment for two hundred and thirteen dollars now
the remaining thirty six dollars is gonna go into her ARS pieces she’s gonna
add that as a supplementary payment and I’ll fill that out look in the chart now
the total cost the total interest cost and this is important for everybody like
how much is it gonna cost me to borrow this twenty five hundred dollars for the
year and repay back the total interest cost is only fifty dollars it’s
relatively low and this is based on that four point seven five percent interest
rate that we put in so the adjusted loan amortization is ten months so basically
she’s gonna have it paid off by the end of ten months we’re gonna look at the
loan amortization table we’re gonna click on that and basically what that
shows us is that the loan balance is twenty five hundred the first payment of
two hundred thirteen dollars two hundred thirteen goes to principal zero goes to
interest and the loan balance is paid down then the the next month you still
make a payment of two thirteen the principles one ninety four and the
interest is eighteen ninety five so this eighteen ninety five is actually the
interest for both months I don’t know why it’s calculating out like that but
that’s what it’s doing third month two hundred and thirteen dollars the
principal two hundred and five eight dollars in interest this is in the
fourth month where Alice has taken her five hundred dollars extra and she’s
applied that as an extra payment to the law so to her payment instead of being
two hundred and thirteen dollars is actually seven hundred and thirteen
dollars so she still pays a little bit of interest but a huge amount goes to
the principle which we scroll down to the bottom and we can see that at month
ten or in December the the balance on the loan remaining is zero and she
hasn’t invested her $2,500 now let’s put this into a spreadsheet to show the
returns on investment so if we go back to our sheet I’ve copied and pasted the
information from the RBC website see the payments – thirteen – thirteen –
thirteen this larger one to five hundred dollars more seven thirteen right down
to the bottom and the the loan balance goes down we could see the calculation
how much interest is paid works out to the same what happens with the RSP
immediately when she gets the loan she she owes that money but she takes that
money she puts it in the RSP we’re RSP contribution of twenty five hundred now
the RSP values twenty five hundred as I said before they’re gonna she’s going
that’s $250 per month 213 plus 36 27 equals 250 so that her her contribution
per per month is the same as Bob’s $250 so the value is increasing a little bit
faster at the end of the year when we can look at all of these payments she’s
made a total payment of twenty five hundred dollars out of pocket over the
course of the year of course this doesn’t include the five hundred dollar
refund that she got because that was money that she wouldn’t have gotten had
she not put in the money into the RSP the RSP value is it three thousand one
hundred and eleven dollars and she is put in twenty five hundredths so she is
effectively made six hundred and eleven dollars compared to Bob’s eighty one
dollars there’s one other factor that we have to consider and that’s the $2,500
that Bob put in during 2019 in 2020 in his return he’s actually going to get
the same $500 back that Alice received in extra refund and this is kind of a
residual thing I’m actually gonna make a separate video on this well put the link
up above when I’ve got that in there and you guys can check out that video
because it’s gonna show the breakdown the trickle-down effect of the marginal
tax rate and the RSP refund that you get from that anyways I’m gonna show you the
quick numbers we’re just gonna go through it basically what happens is
each year subsequently if they keep reinvesting that refund they just
continue to get a little bit more of an extra refund looking at after five years
of residual income twenty-five hundred dollars invested by Alice is worth four
thousand five hundred nineteen dollars the twenty five hundred dollars invested
by Bob is worth four thousand four hundred eighty three dollars the
difference is less than forty dollars difference between the two if we change
this rate to zero percent even though the RSP value was greater at the
beginning in this lump sum she’s actually returned less at a zero percent
return so the big takeaway from this is you know but Alice is making a little
bit more money she’s paying definitely some interest she actually makes a
little bit more return because she’s invested sooner but if the mark
it is going down Bob’s getting the benefit of dollar cost averaging and I
think for the amount of work that Alice had to do applying for the loan making
sure the loan payments go through transferring extra money in with her RSP
each month and Bob just has a straight-up contribution I mean I would
personally would probably go with Bob’s approach just make that contribution
automatic and get rich over the long-term anyways I hope you guys
enjoyed this video remember to hit the like button down below subscribe if you
haven’t turned on your notifications bell and let’s get rich together

7 comments on “RRSP Loans: is borrowing to invest worth it?”

  1. Drawbridge Finance says:

    Let me know what topic to cover next!

  2. Patrice Melancon says:

    Thank for the video. Very well done as usual. There is another situation where borrowing can be profitable. Let say you already contributed $10 000 to your RRSP an marginal tax rate is 35%. How much can you borrow so the amount you borrow equal to the total tax return of the $10 000 + the borrowing? Lets do the math.

    x is the ammount we are borrowing. The equation look like that: x= (10 000+x)X35%. The solution is x=3 500/.65 or x=5 384.

    The total contribution would be $15 384. The tax return of $5 384 would be received 4 months after the borrowing and only a smaller interest has to be paid. (I guess $70)

    The extra $5 000 dollars would generate income immediately. If we do not do that and wait the $ 3500 tax return and invest it in June we are losing 4 months of income and for the rest of the year, we have less money to generate income. If invested in a RRSP this amount would generate a tax return of $1225 in June of the following year. And that $1225 return, if invested in RRSP would generate a tax return of $428 2 years after the initial re investement. Lets do that again and at year 3 we have another $150 to invest and then we reach almost the same amount of inversting we have in the borrowing scenario.

    You better than me to put that in a Excel sheet. I hope you can plot that with the interest return etc. My guess is that it can be a profitable use of borrowing.

  3. The Entrepreneur Channel says:

    I'd love an updated video on your stance on cryptocurrencies going into 2019

  4. Abdullah Dimion says:

    not deleting comment because it was posted, but my information was wrong. Thanks to Bob Lau for pointing it

    Marginal tax rate is important for tax refund for sure on the RRSP itself, but it is also important on the loan itself because the interest is a write off.

    Say one has a portion of his income in the 40% rate and they gets say 4% interest on the loan after the write off they really only pay 2.4% interest. Will adjust my comment if your video covers this. Just didnt want to forget to mention it because you are usually extremely thorough.

  5. Paul Hanusiak says:

    Does being self employed change anything with regards to investment strategy? What about being incorporated vs not?

  6. hinderyckxg says:

    Interesting. Could you also make a topic for us European viewers? Understandably you post a lot about the Canadian and Us market and ways to invest but for example, you talked once about Robinhood, an easy way (almost) no fee way to invest in stocks. Nevertheless, one can't use this way because not possible if you are resident in Europe. There are some that we could use but some of them apps are restricted to the UK, so no solution either there, would there be a thrustworthy investment app, usable for all European residents, no matter the country there?

  7. Feynar says:

    Solid video, thanks!

Leave a Reply

Your email address will not be published. Required fields are marked *