Making Regular Contributions to your RRSP instead of RRSP Loans

Many people ask their RRSP issuer to take money directly from their bank accounts the day after they have their pay cheques deposited. On the other hand, there are droves of people who take out a loan every February to make their lump sum contribution before the deadline – only to have to make monthly payments on their RRSP loan until the following year.

MagnifyingGlassOnPrint.jpgIf you have the ability to get out of the rut of annual RRSP loans – there are a couple of advantages. BUT with our society being more disposed to financing everything as opposed to saving for everything, sometimes the only way to get people to save is to get the RRSP loan. Making a mortgage payment or car loan payment usually takes priority over savings since there are no immediate and potentially crippling consequences to not making a monthly savings contribution like there is with missing a loan payment.

Opportunity Cost 

If you can commit to making your savings automatic, one immediate gain is that you won’t have interest to pay on these annual loans. As a simple example, let’s take someone who takes out an annual loan of $10,000 for their RRSP contribution every year and let us further assume that the average rate of interest on these annual loans is 7%. If they contribute to their RRSP every year from age 30 to 70, that’s 40 years of paying $700/year in interest – for a grand total of $28,000 over their career.

If you instead took that $700 dollars and contributed it to your RRSP, and assuming a rate of return of 8% on your investments, you are looking at a whopping difference of about $195,000!

Dollar Cost Averaging

Another advantage is that you might be able to sleep a little more soundly at night. This is because the monthly payments help to mask the volatility of your portfolio. This is best described using an example. Let’s say that we have a mutual fund that starts the year on January 1st with a NAV of $10.00 per unit. Let us further assume that the unit price changes as follows for the next 6 months:

January = $10.00/unit
February = $9.25/unit
March = $9.00/unit
April = $8.75/unit
May = $9.00/unit
June = $9.75/unit

Let us further assume we have someone who purchases $100 worth of units per month on an automatic savings plan and another investor who just puts in a lump sum of $600 at the beginning. For the lump sum investor we know that he can buy 60 units of the fund since $600 divided by $10.00/unit equals 60 units. But for the "Dollar Cost Averager", he buys 10 units in January ($100 divided by $10/unit), 10.81 units in February ($100 divided by $9.25/unit), 11.11 units in March, 11.43 units in April, 11.11 units in May and 10.26 units in June for a total of 64.72 units.

Since the price in June is $9.75, we know that 60 units will be worth $585.00. So the lump sum investor had purchased 60 units in January, saw his investment go down in value and never return to it’s original price.

His monthly statements would have looked like this:

January = $600
February = $555
March = $540
April = $525
May = $540
June = $585

In other words, he saw a lot movement in his portfolio’s value (and a lot of it downwards!). Compare this to the Dollar Cost Averager whose statements looked like this:

January = $100
February = $192
March = $287
April = $379
May = $490
June = $631

His portfolio’s value went up in absolute terms every month even though he was buying the same investment – and since he was able to buy more units when the unit values were down he actually ended up with a gain at the end of the same time period even though he had invested no more than the lump sum method… His average cost was $9.27/unit when you do the math (as opposed to $10.00/unit for the lump sum investor).

Of course, if the mutual fund had just steadily marched higher and higher in unit value than the lump sum investor would be better off since his investment’s cost would be lower than someone whose average cost only increased with each successive monthly contribution – but you get the point.

So if you are just getting your feet wet with investing and RRSP’s – here are two reasons to start with automatic contributions: 1) Savings tens (if not hundreds) of thousands of dollars in interest payments and foregone growth on those interest costs and 2) helping you deal with portfolio volatility.

Once your portfolio gets big enough, the monthly fluctuations in your portfolio will be larger than your monthly contributions, but don’t worry – that’s normal, and there will normally (hopefully!) be more months where the fluctuations are POSITIVE as opposed to NEGATIVE! :)

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Preet Banerjee
Preet Banerjee an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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  • stefan

    I would like to suggest perhaps a future topic that you could write about, that is related to this.

    There are some cases where use an RSP loan in Feb. can help you "double" your contributon for the year. The typicall scenario is you do your monthly contributions, and you also take out a loan at the end of year, then using your tax refund to pay off the loan. This technic really grows your RSPs faster, while the interest charges are small, since you pay off the loan very quickly.

  • Preet

    Hi Stefan, thanks for the comment – you are quite right this is another RRSP Loan strategy that many people employ and I will definitely do a write up on it – it is on my list of to-do’s for RRSP topics.

    Also, I will talk about just filling out the form that reduces your taxes withheld at source, so that you don’t have to wait until tax time to get your refund – you’ll get it all along, therefore you can increase your monthly contributions and get the same effect.

    Thanks Stefan!

  • Adeem Zafar

    Nice posting. Do you think it is advisable to use dollar-cost averaging for US dividend stocks or just on mutual funds?

  • Preet

    Hi Adeem – the only way to buy stocks (that I know of) without killing yourself with commissions is to set up a Share Purchase Plan with the company directly to avoid the brokerage commissions.

    Some have the ability to allow purchases for as little as $50/month at a time, etc.

    So you could use dollar cost averaging with stocks, and yes, I think it is generally a good idea to do so – especially if you are just starting out.