Wednesday, February 14, 2007

RRSPs: borrowing to invest

Motivated by madjenny's and false phophet's questions/comments, I have decided to do second (shorter) posting on RRSPs.
Two fun questions: bi-weekly payments or borrowing with bi-weekly payments? where should I put my money?

Answer 1: an example ...

Choice One: If you make bi-weekly payments (26 a year) of $38.46 you will have saved $1000 over the year, and (assuming a 7% return) you have made almost $35 in interest. From your 2007 tax return, so you will earn (assuming you live in Ontario, with a $40K income) $310 dollars from CCRA.

Choice Two: If you borrow $1000 today and make your RRSP contribution before March 1st, your contribution is tax deductible. So you will earn $310 dollars on this year's tax refund, and you will gain interest (again assuming 7% return) is $70 over the next 12 months. The only cost to borrowing is the interest charges (at 6% is roughly $33). You can make the same bi-weekly payments as in Choice One plus an extra $1.30 to cover the interest cost. And if you put your $310 tax refund into your RRSP, you can get the tax refund for it in 2007 tax year (another $91 in your pocket or RRSP) and the interest you get on the extra $310 in your RRSP over the next year (about $20 in earnings).

So the difference between bi-weekly contributions and borrowing to invest is not insignificant. Of course, this holds interest rates and returns constant to make life simple, but you get the point.
Here is a Marginal Tax Rate Calculator

As for the second question:
Nothing is more valuable than great broker who spends their whole day doing research on companies that you should invest in. Because a mutual fund is "a basket of assets", the risk is lower than holding an individual stocks, and fund managers probably are the right people to be choosing what stocks to by in a given industry. I think they're great, but a broker is need to help pick the good ones.

I hope that was helpful and interesting!


MadJenny said...

Wow! Very informative! Thanks. I might think about borrowing to max out my RRSP for this year.

Anonymous said...

One thing I always wonder about is our expectation of a 7% return. Industry types always talk about the how much your RRSP will be worth after 40 years of putting in $100 a month. But they always say,...assuming a 7% return. But should we really expect that much of a return? Looking over Canadian Mutual funds at the Globe & Mail website, only one third of Canadian mutual funds had a 7% or more return after 10 years. So clearly some do well but i think a lot of people are going to be disappointed with their mutual fund returns over time. And looking at the future, I'd have to say that returns will be lower. I base that on baby boomers retiring enmass over the next 10-15 years and their effect on the market. In particular, few of them have the funds saved for retirement so therefore will have to liquidate assets (investments/housing) to survive. I suppose there could be many effects on the market but I can't see all those withdrawas as being "good" for the market. Anyway, I do think RRSPs are good, I just tend to think that people's expectations are falsely elevated by the industry which has an interest in selling more mutual funds.

CousinJenny said...

interesting... i never think about these things.. but i did say that i'd start investing when i was 25, and come september i'll be there... so maybe i should wipe the dust off that rrsp with a whopping 50$ in it and start up again..

Canadian Economist said...

Hi anonymous, thanks for your thoughts. Sorry it has taken me so long to reply. First: is 7% a reasonable assumption? It is true that not all funds do this well, but my personal view is that that you should demand at least 7% return on your money (on say a 3 year average). But you have to be willing change your broker if they fail you. Here is one example I chose at random on the net as a good example of a well managed fund (look at the long-term performance). As for the net effect of the Boomers, it is hard to say. People will have to pull money out of the market, but people will also be putting money in (both slowing over time). And, in fact, there are more important factors that determine returns (such as relative prices industry specific performance).