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RRSP Catch-up

Every now and then financial institutions come up with a nifty idea to help you with your financial planning. Every now and then they come up with a stinker. Last RRSP season saw the high-powered marketing of a long-term up-to-$50,000 loan designed to help you catch up your unused RRSP contribution room. This isn't a product I'm particularly crazy about. Let me elaborate.

The Cost of Borrowing. For years financial advisors have said it's a good idea to borrow to make your RRSP contribution providing you can repay your loan within one year. The appearance of a ten-year loan might have you asking, "What's changed?" Nothing. The cost of borrowing for ten years is very expensive. (See sidebar) While the earlier you get your money into an RRSP the better because of the impact of compounding, remember that your loan interest is not deductible. Is this ever a good idea? Yes. If you have an enormous taxable income and can take the full deduction, or if you believe your marginal tax rate will be going down dramatically, taking advantage of the loan may make sense, providing you can work the monthy repayments into your cashflow easily. Which brings us to point number two.

Watch out for a cash flow crunch. A $50,000 loan taken for 10 years at six percent gobbles up $555 a month from your cash flow. If interest rates go up you could find your payments increasing putting more pressure on your budget, since the loan rate is only fixed for the first year. Let's say interest rates rose to eight percent. Your payment would increase to $607 a month, and the overall cost of the loan would jump to $22,062. If interest rates went higher, you might find yourself unable to meet your loan commitment.

The other question to ask yourself is this: "With interest eating up a large slice of your budget pie, can you afford to make your regular RRSP contributions?" If the answer is "No", at the end of the ten-year loan, you'd have to catch up the contributions you didn't make while you were repaying the loan. Sounds like a Catch-22 to me. Instead, try this recipe. Make your maximum RRSP contributions using a monthly investment plan. Also contribute the amount you would have made in loan payments to your RRSP on a monthly basis. It may take a little longer to catch up, but you'll have no interest costs. All your money will be working for you.

Buyer beware

Don't assume financial institutions that have been aggressively marketing catch-up loans are the only ones with something to offer. Almost any financial institution would be happy have you as a customer if you're a good credit risk. Shop around for the best rate to minimize your interest costs. And negotiate. The posted rate isn't the bank's best rate. Offer to consolidate your RRSPs and other investments, move your mortgage when it matures, or transfer your corporate business to the branch in exchange for a better rate.

Borrowing to catch up may make good sense for some people. Deciding how much to catch-up at any one time is the key to making the strategy work for you. Plan ahead and have a little patience. You'll save scads of interest while still maximize your RRSP's growth over the long term.

The Cost of Borrowing

A $50,000 loan for 10 years at an average interest rate of six percent would cost $16,159 in interest over the life of the loan.

A one-year loan for $6,400 (to give you the same monthly payment amount) for 7.81 years (to borrow a total of $50,000) at the same interest rate would cost only $1,375 for an interest savings of $14,784.

Assuming an annual growth of nine percent, $50,000 contributed all at once would grow to $160,357 after 20 years. Smaller conttibtions of $6,400 made over about eight years would grow to $135,108 in the same 20 years, so your RRSP would be off about $25,000 .

The question you have to ask yourself is, "Is it worth spending almost $15,000 in interest to get $25,000 of growth in your RRSP over 20 years?"

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Gail Vaz-Oxlade is a best-selling author, regular contributor to various publications and the host of the television series Till Debt Do Us Part.