Catch-up, top-up or gross-up?

The challenge facing clients is avoiding the temptation to maximize their loans at all costs — those catch-up loan advertising campaigns are powerful — while having the discipline to put the income-tax refund toward repaying the loan. Many a cheque has arrived in the mailbox and been opened with the best of intentions, only to be used for “retail therapy.”

Negative sentiment

Talbot Stevens, a financial consultant and author of <i>The Smart Debt Coach</i> in London, Ont., which will be published this month, says the duration of an RRSP loan is directly proportional to the amount of negative sentiment directed toward it.

“Gross up” loans, which are paid off in a matter of weeks using the resulting income-tax refund, have their supporters. So do “top up” loans, in which the tax refund covers a portion of the loan, the remainder of which is repaid within a year. The most contentious type of RRSP loan is the “catch up” loan, in which larger sums are borrowed to max out previously unused contribution room, requiring a longer repayment period.

Stevens believes borrowing for an RRSP is “good debt,” and even the most cautious of consumers can look at it as a strategy with opportunities.

A typical client in the 40% income-tax bracket with $3,000 to invest in an RRSP is likely to spend the resulting tax refund. By doing so, the client has put away only $1,800, on an after-tax basis, toward his or her retirement.

Instead, Stevens recommends a gross-up loan of a further $2,000, to bring the total RRSP contribution up to $5,000: “[The client] will get a refund of 40% of the $5,000, which is $2,000. And that pays off the loan completely. That’s one way of borrowing for RRSPs where you truly can’t lose.”

Andrew Krahn, a wealth advisor with ScotiaMcLeod Inc. in Winnipeg, has a checklist he goes over with clients before he advises taking out any RRSP loans. First, the interest-rate environment has to be favourable. Second, the client must have sufficient cash flow to be able to pay back the loan before borrowing for the following RRSP season.

“I don’t want to see someone build up an excess amount of borrowing and not pay it off regularly,” Krahn says. “Then you’re just building up a liability and an asset at the same time.”

Increase net worth

Krahn considers larger loans to be too risky because the client could end up paying more if interest rates go up.

“In the end, we want to make sure what we’re recommending is increasing [the client’s] net worth,” Krahn says. “If you don’t pay off your loans efficiently, you’re not increasing your net worth as quickly as you could.”

Short-term RRSP loans can prove to be beneficial for clients who are starting to build their retirement assets. But such a strategy may not hold true for some older clients, for whom contributing more money into an RRSP may not be the best move, says Krahn: “There can be unique circumstances that may warrant not putting more money into an RRSP. They might be getting too much money [in taxable retirement income] and paying too much tax.”

There are circumstances in which even the Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada), believes borrowing to invest is a good idea.

“As little leverage as possible”

“You want to have as little leverage in your portfolio as possible,” says Lindsay Speed, FAIR Canada’s legal counsel and corporate secretary. “Generally, it magnifies risk in any investing situation. That’s not to say it can’t be used appropriately in some circumstances. But, for most retail inves-tors, it’s not appropriate due to the high risk.

“If you’re investing twice the money,” Speed adds, “and half of it isn’t yours and you lose it all, you’re doubling the amount you lost and you still have the obligation to repay the borrowed money. But for investors with an appropriate risk profile and the ability to repay [the RRSP loan], it can be used.”

A loan strategy can enable your clients to benefit from the peaks and troughs in the market, according to Stevens. The average one-year return for the S&P/TSX composite index from 1956 to 2012 is 10%. After a significant market drop, he says, it’s practically common sense that returns will return to the mean.

“If you want to catch up,” Stevens says, “it’s safer and more profitable to borrow to invest a lot more when the market is down. It’s an opportunistic approach. You stick with the safe, guaranteed return of paying down your personal debts until that market gives you a good opportunity.” IE