Last week's column on borrowing to invest prompted a bunch of questions from readers. Today, I'll answer some of these questions with the help of outside experts.
If an investor were to borrow to invest in his/her registered retirement savings plan (RRSP), can the bank take the investment as collateral for the loan?
RRSP loans are typically unsecured, which means no assets are pledged as collateral, said Talbot Stevens, a financial industry consultant and author of The Smart Debt Coach. As with a credit card, approval for the loan is based on your credit history. So, if you take out an unsecured RRSP investment loan and fail to pay it back, the bank can't seize your RRSP. It will, however, find other ways to attempt to collect on the debt.
Can RRSP assets ever be pledged as security on a personal loan?
Yes, but it's rare and generally not a good idea. That's because the RRSP assets pledged as security must be included in the borrower's income for that year, leading to a potentially large tax hit. When the RRSP property is no longer pledged as collateral, the RRSP holder can claim a deduction for the assets.
"Because of the taxation issue, and the administrative complication, I would not recommend using RRSP assets as collateral for any loan," Mr. Stevens said.
Even if you wanted to use your RRSP as security, there's a good chance your financial institution won't let you. There are no laws against pledging RRSP or registered retirement income fund (RRIF) assets as collateral, but "we don't allow it," said Jamie Golombek, managing director of tax and estate planning at CIBC Private Wealth Management.
"My understanding is that no major financial institution allows their RRSPs or RRIFs to be pledged as collateral for a loan. Generally, it's not in the best interest of the client," Mr. Golombek said.
For an individual to use an RRSP as collateral the financial institution that holds the RRSP account "would have to play along," but finding a willing participant could be difficult, he said.
"In most cases RRSP loans are either unsecured or if security is taken it's taken against something else such as a non-registered asset or a piece of real estate," he said.
Can I deduct interest when I borrow to invest in an RRSP or tax-free savings account (TFSA)?
No. Interest is only tax-deductible if you're investing in a non-registered account. Furthermore, for interest to be deductible the borrowed funds must be used to purchase eligible property that either produces income now (such as dividends, interest or rent) or has the potential to produce income. That would include a company, for example, that does not pay a dividend now but may initiate a dividend in the future, but it excludes a company whose stated policy is to never pay a dividend or distribution of any kind.
What do you think of RRSP catch-up loans?
For many people, borrowing to invest in an RRSP is a bad idea, and not just because interest isn't deductible. If you can't scrape together the cash for an RRSP contribution, you may have deeper spending, saving and budgeting issues that need to be addressed first. If you try to borrow your way to prosperity, you could end up digging yourself into a bigger hole.
Financial institutions will tell you otherwise, of course. They'll dangle the prospect of a juicy refund in an attempt to convince you to take out an RRSP loan. They win in two ways – by having more assets under management that generate fees, and by earning interest on the loan.
There are, however, instances where a financially responsible individual who is facing short-term cash flow constraints can benefit from an RRSP loan. For example, say your marginal tax rate is 40 per cent and you have $6,000 of cash and $10,000 of unused RRSP contribution room. You could borrow $4,000, contribute the maximum $10,000 to your RRSP, and then use the $4,000 tax refund to repay the loan after a couple of months with minimal interest costs. This strategy effectively converts $6,000 in after-tax dollars (outside the RRSP) into $10,000 in pretax dollars (inside the RRSP, where it can grow tax-free).