We are a nation of debtors. According to a recent CIBC World Markets report, Canadian households are in debt to the tune of $140 for every $100 of income. Our life cycle of debt begins with student loans to pay for our education. Then, it's graduation and borrowing money to buy a car.
Once out in the work force, we wield credit cards to fund our lifestyle and frequently pile up outstanding balances. If money is tight, we'll draw on a line of credit from our bank. Eventually, we join the ranks of homeowners and take on the biggest debt of all, a mortgage.
If you count yourself among the ranks of the indebted, now is a good time to review your debt obligations. As the annual barrage of RRSP season ads hits the media, pause and consider this question: should you pay down your existing debt or make an RRSP contribution for the 2009 tax year? The answer, as with most things financial, is: it depends upon your personal situation.
If it is in your nature to be troubled by the fact that you owe money and have monthly loan payments to meet, then paying down debt may be your best option if it gives you peace of mind. Because Canada Revenue Agency lets taxpayers carry forward any unused RRSP contribution room to future tax years, this approach is not without merit from a financial viewpoint, too.
For example, a young worker could pay down debt now and make a larger RRSP contribution later in her career when her income is taxed at a higher rate, thus receiving a bigger tax refund per RRSP contribution dollar.
For those untroubled by debt, the debt vs. RRSP contribution decision is best explored by crunching a few numbers. Fortunately, there are online calculators that make this process reasonably simple. Let's look at several scenarios that assume an annual income of $75,000, a marginal tax rate of 35% and $10,000 to deploy.
If you are carrying an outstanding balance on your credit card, should you use the money available to make an RRSP contribution? You pay dearly for the privilege of borrowing from your credit card company, probably an interest rate close to 20%, compounded monthly.
The "Should I pay off debt or invest" calculator at the Investor Education Fund web site, suggests that an investment would need a return rate of about 22% or higher (depending on the tax rate on your RRSP profits) to equal the return achieved by paying off your credit card balance.
In my opinion, a realistic long-term return rate for an RRSP holding a diversified portfolio is 6% to 8%. Consequently, it almost always makes the best sense to pay off outstanding credit card balances and bank your RRSP contribution room for future use.
Interest rates on new car loans are currently averaging about 7%, compounded monthly. The aforementioned debt vs. investment calculator suggests that you would need to earn a return rate of at least 7.2% on your RRSP to match the return from paying off your car loan. The guaranteed return is to pay off the car loan, and that is probably the best place to apply your $10,000 in this case.
Student loans are another story. The interest rate is often lower than a normal consumer loan, plus there is a federal tax credit available on the interest paid on qualifying loans. You'll need to run the numbers for your own situation, but for many, using the money for an RRSP contribution will be the more beneficial option.
Much has been written about whether homeowners should use any available cash to pay down their mortgage or to make an RRSP contribution. As a rule of thumb, if you expect the average return rate on your RRSP will be higher than the interest rate on your mortgage, an RRSP contribution is the more profitable choice. With today's unusually low interest rates -- five-year closed mortgages at about 5% and variable mortgages rates even lower -- an RRSP contribution could make the most sense this year.
If your theoretical $10,000 goes into your RRSP, the Ernst & Young 2009 RRSP savings calculator predicts a tax refund in the order of $2,900 to $3,800, depending on the province/territory where you live. Applying this refund to reduce any personal debt is an excellent way to reconcile the debt vs. RRSP conundrum.
There is another side to the debt vs. RRSP discussion. What if you have no cash? Should you take on debt in order to make an RRSP contribution? I believe this is only a good idea in very limited circumstances, for instance if you are in a high marginal tax bracket and the tax refund is applied to the loan, and you pay off the loan before the next RRSP season. Instead of borrowing for an RRSP contribution this year, I recommend rearranging your budget for the coming year (and beyond) to include an automatic transfer of money from every pay cheque to your RRSP account.
Partaking of some form of debt is almost unavoidable in 21st century society. If you do have personal debt and are wondering whether to pay down debt or make an RRSP contribution, I leave you with this parting thought: paying down debt yields a sure return, while RRSPs may not.