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RRSP vs. Paying Down Debt

October 10, 2007

A close friend of mine, who is not to be named in this article, is in a bit of a pickle. They recently got a cheque in the mail, and wanted to know what to do with it.They don’t own a house, but somehow have mustered a $20,000.00 debt while buying the “car of their dreams” (and probably a few too many shoes) . They make a modest income, but spend poorly, and want to work on their debt. There’s a lot of articles out there on paying down mortgage vs. paying into RRSP, but, that’s not what we want to explore. A mortgage is a complicated beast in a labyrinth of twists and turns and changes. We just want a very specific question answered:

RRSP vs. Debt Alleviation

If you need to find out about RRSPs in general, first try this article over at the Starving Student Survival Strategies called RRSPs, I’ve got bigger things to worry about. It’s a great page on why you should invest in one, what it is, etc.

For dry technical information on RRSPs, please take a look at these resources:

Let’s get started.

Here’s a few facts we’ll need to start off with

  • The cheque is for $2785.24
  • The debt is $20,000.00 on line of credit (exactly how they got a line of credit without owning a house is beyond me).
  • The interest on the debt is about 8% per year. Each month, the minimum payment is 3% (this includes the amount outstanding, PLUS monthly interest)
  • Invested in an RRSP, the rate of return could probably be about 5%.

OK. We have just about everything we need to build a mathematical case… Read more!

Minimum Payments Suck.

First off, paying off her debt just by making minimum payments will never happen based on our formula. Here’s a sample of that payment schedule:

Month-Year Month-Number $Owing Interest $Total $Min-Payment
Oct-07 1 $20,000 133.33 $20,133 $604.00
Oct-08 13 $15,029 100.19 $15,129 $453.86
Oct-09 25 $11,293 75.28 $11,368 $341.05
Oct-10 37 $8,486 56.57 $8,542 $256.27
Oct-11 49 $6,377 42.51 $6,419 $192.57
Oct-12 61 $4,792 31.94 $4,823 $144.70
Oct-13 73 $3,601 24.00 $3,625 $108.74
Oct-14 85 $2,706 18.03 $2,724 $81.71
Oct-15 97 $2,033 13.55 $2,047 $61.40
Oct-16 109 $1,528 10.18 $1,538 $46.14
Sep-17 120 $1,176 7.83 $1,183 $35.50

OUCH! After 10 years, their amount owing will be $1,183.00. In the meantime, they will have paid over $5340.53 for the interest alone! STOP NOW!

Because we are sitting pretty making $604.00 monthly payments and still living comfortably, let’s continue that for as long as we can:

Month-Year Month-Number Owing Interest Total Payment
Oct-07 1 $20,000 133.33 $20,133 $604.00
Nov-07 2 $19,529 130.19 $19,660 $604.00
Dec-07 3 $19,056 127.03 $19,183 $604.00
Jan-08 4 $18,579 123.85 $18,702 $604.00
Feb-08 5 $18,098 120.65 $18,219 $604.00
Mar-08 6 $17,615 117.43 $17,733 $604.00
Apr-08 7 $17,129 114.19 $17,243 $604.00
May-08 8 $16,639 110.92 $16,750 $604.00
Jun-08 9 $16,146 107.63 $16,253 $604.00
Jul-08 10 $15,649 104.32 $15,754 $604.00
Aug-08 11 $15,150 100.99 $15,251 $604.00
Sep-08 12 $14,647 97.64 $14,744 $604.00
Oct-08 13 $14,140 94.26 $14,235 $604.00
Nov-08 14 $13,631 90.87 $13,721 $604.00
Dec-08 15 $13,117 87.44 $13,205 $604.00
Jan-09 16 $12,601 84.00 $12,685 $604.00
Feb-09 17 $12,081 80.53 $12,161 $604.00
Mar-09 18 $11,557 77.04 $11,634 $604.00
Apr-09 19 $11,030 73.53 $11,104 $604.00
May-09 20 $10,500 69.99 $10,570 $604.00
Jun-09 21 $9,966 66.43 $10,032 $604.00
Jul-09 22 $9,428 62.85 $9,491 $604.00
Aug-09 23 $8,887 59.24 $8,946 $604.00
Sep-09 24 $8,342 55.61 $8,398 $604.00
Oct-09 25 $7,794 51.96 $7,846 $604.00
Nov-09 26 $7,242 48.28 $7,290 $604.00
Dec-09 27 $6,686 44.57 $6,731 $604.00
Jan-10 28 $6,127 40.84 $6,168 $604.00
Feb-10 29 $5,564 37.09 $5,601 $604.00
Mar-10 30 $4,997 33.31 $5,030 $604.00
Apr-10 31 $4,426 29.50 $4,456 $604.00
May-10 32 $3,852 25.67 $3,877 $604.00
Jun-10 33 $3,273 21.82 $3,295 $604.00
Jul-10 34 $2,691 17.94 $2,709 $604.00
Aug-10 35 $2,105 14.03 $2,119 $604.00
Sep-10 36 $1,515 10.10 $1,525 $604.00
Oct-10 37 $921 6.14 $927 $604.00
Nov-10 38 $323 2.15 $326 $325.56

Shortly after 3 years, the debt is paid. The interest paid on this money is $2673.56, which is certainly more reasonable than making just the minimum payments.

Money out of nowhere

The cheque comes as a third-quarter bonus. It’s fantastic. $2785.24

The income taxes have already been paid, and it’s money just waiting to help free them from the financial black-hole spiral that this person is destined for. So the question of this article is, do we invest in RRSP, or do we pay down our debt?

RRSPs give you money back, sort of.

RRSPs are great. They do 2 major things for you

  1. They give you money back into your own pocket. Relax. It’s not *free* money. You’ve already paid taxes on this cheque. Just check your paystub. Usually, this amounts to 30%.
  2. They generate compounding interest , tax-free. You don’t have to pay taxes on the amount they earn every year. Without much risk, the investments that RRSP is sitting in will fetch you about a 5% return, year after year.

So, if the entire $2785.24 is dropped into an RRSP, you can probably expect a cheque from the government in April for $835.00.

Timing is Everything

We are presented with a very specific question now. If we pay back the entire $2785.24 into our debt, will we save more money on the lifetime of our debt than by receiving $835.00 dollars back from the government on or before April 15th, and putting that into our debt.

First off, let’s forget about the amount of money generated by gaining interest in the RRSP. Here’s an example of what it would look like if we put the entire cheque into the debt.

Month-Year Month-Number Owing Interest Total Payment
Oct-07 1 $20,000 133.33 $20,133 $604.00
Nov-07 2 $19,529 130.19 $19,660 $604.00
Dec-07 3 $19,056 127.03 $19,183 $604.00
Jan-08 4 $18,579 123.85 $18,702 $604.00
Feb-08 5 $18,098 120.65 $18,219 $604.00
Mar-08 6 $17,615 117.43 $17,733 $604.00
Apr-08 7 $17,129 114.19 $17,243 $604.00
May-08 8 $16,639 110.92 $16,750 $604.00
Jun-08 9 $16,146 107.63 $16,253 $604.00
Jul-08 10 $15,649 104.32 $15,754 $604.00
Aug-08 11 $15,150 100.99 $15,251 $604.00
Sep-08 12 $14,647 97.64 $14,744 $604.00
Oct-08 13 $14,140 94.26 $14,235 $604.00
Nov-08 14 $13,631 90.87 $13,721 $604.00
Dec-08 15 $13,117 87.44 $13,205 $604.00
Jan-09 16 $12,601 84.00 $12,685 $604.00
Feb-09 17 $12,081 80.53 $12,161 $604.00
Mar-09 18 $11,557 77.04 $11,634 $604.00
Apr-09 19 $11,030 73.53 $11,104 $604.00
May-09 20 $10,500 69.99 $10,570 $604.00
Jun-09 21 $9,966 66.43 $10,032 $604.00
Jul-09 22 $9,428 62.85 $9,491 $604.00
Aug-09 23 $8,887 59.24 $8,946 $604.00
Sep-09 24 $8,342 55.61 $8,398 $604.00
Oct-09 25 $7,794 51.96 $7,846 $604.00
Nov-09 26 $7,242 48.28 $7,290 $604.00
Dec-09 27 $6,686 44.57 $6,731 $604.00
Jan-10 28 $6,127 40.84 $6,168 $604.00
Feb-10 29 $5,564 37.09 $5,601 $604.00
Mar-10 30 $4,997 33.31 $5,030 $604.00
Apr-10 31 $4,426 29.50 $4,456 $604.00
May-10 32 $3,852 25.67 $3,877 $604.00
Jun-10 33 $3,273 21.82 $3,295 $604.00
Jul-10 34 $2,691 17.94 $2,709 $604.00
Aug-10 35 $2,105 14.03 $2,119 $604.00
Sep-10 36 $1,515 10.10 $1,525 $604.00
Oct-10 37 $921 6.14 $927 $604.00
Nov-10 38 $323 2.15 $326 $325.56
  • Over the total period of the loan, by NOT dumping the lump sum into debt, total interest paid is $2673.56.
  • Over the total period of the loan, by dumping the entire lump sum into the debt, total interest paid is only $1941.48.
  • This is a savings of $732.08.
  • The loan would be paid off 6 months quicker by not buying a new boat with the money ;).

Now let’s see what happens when we put the tax-return on our RRSP into the debt in April 2008:

Month-Year Month-Number Owing Interest Total Payment
Oct-07 1 $20,000 133.3333333 $20,133 $604.00
Nov-07 2 $19,529 130.1955556 $19,660 $604.00
Dec-07 3 $19,056 127.0368593 $19,183 $604.00
Jan-08 4 $18,579 123.857105 $18,702 $604.00
Feb-08 5 $18,098 120.6561524 $18,219 $604.00
Mar-08 6 $17,615 117.43386 $17,733 $604.00
Apr-08 7 $16,293 108.6196058 $16,402 $604.00
May-08 8 $15,798 105.3170698 $15,903 $604.00
Jun-08 9 $15,299 101.9925169 $15,401 $604.00
Jul-08 10 $14,797 98.64580039 $14,896 $604.00
Aug-08 11 $14,292 95.27677239 $14,387 $604.00
Sep-08 12 $13,783 91.88528421 $13,875 $604.00
Oct-08 13 $13,271 88.4711861 $13,359 $604.00
Nov-08 14 $12,755 85.03432734 $12,840 $604.00
Dec-08 15 $12,236 81.57455619 $12,318 $604.00
Jan-09 16 $11,714 78.0917199 $11,792 $604.00
Feb-09 17 $11,188 74.5856647 $11,262 $604.00
Mar-09 18 $10,658 71.0562358 $10,729 $604.00
Apr-09 19 $10,125 67.50327737 $10,193 $604.00
May-09 20 $9,589 63.92663255 $9,653 $604.00
Jun-09 21 $9,049 60.32614343 $9,109 $604.00
Jul-09 22 $8,505 56.70165106 $8,562 $604.00
Aug-09 23 $7,958 53.0529954 $8,011 $604.00
Sep-09 24 $7,407 49.38001537 $7,456 $604.00
Oct-09 25 $6,852 45.6825488 $6,898 $604.00
Nov-09 26 $6,294 41.96043246 $6,336 $604.00
Dec-09 27 $5,732 38.21350201 $5,770 $604.00
Jan-10 28 $5,166 34.44159202 $5,201 $604.00
Feb-10 29 $4,597 30.64453597 $4,627 $604.00
Mar-10 30 $4,023 26.82216621 $4,050 $604.00
Apr-10 31 $3,446 22.97431398 $3,469 $604.00
May-10 32 $2,865 19.10080941 $2,884 $604.00
Jun-10 33 $2,280 15.20148147 $2,295 $604.00
Jul-10 34 $1,691 11.27615802 $1,703 $604.00
Aug-10 35 $1,099 7.324665737 $1,106 $604.00
Sep-10 36 $502 3.346830175 $505 $505.37

Let’s recap:

  • Over the total period of the loan, by NOT dumping the lump sum OR the tax return into debt, total interest paid is $2673.56.
    The life span of repayment this way is 38 months
  • Over the total period of the loan, by dumping only the tax return into the debt in April, total interest paid is only $2480.94.
    The life span of repayment this way is 36 months.
  • Over the total period of the loan, by dumping the entire lump sum into the debt, total interest paid is only $1941.48.
    The life span of repayment this way is 32 months

RRSP Chart 1

What We Are Forgetting.

So, from what we’re seeing above, the best option is to dump the lump sum against our debt. We pay less interest over the period of the loan, and we finish it faster.

Hold your horses.

That $2785.24 didn’t just disappear. It’s sitting there, making money. Not only that, because you put it into RRSP, you’ve managed to squeeze an extra 30% out of it to put on your debt. Here’s the things we need to consider in order to look at the big picture:

  • What’s the amount of money the RRSP will have made by the time you pay off your debt
  • How long after you pay off your debt will you have to make regular payments to get “caught-up” to the amount of the RRSP and the interest it would have generated?

Update, thanks to a keen observer, the RRSP interest examples were listed for 4 years, and should have been listed for 3, which skews the outcome. Thanks for your keen eye, Mr. X!

Year, $ Opening Balance, $ Compounded Interest, $ Closing Balance

October 1 2007, $2,785 $116 $2,901
October 1 2008, $2,901 $121 $3,022
October 1 2009, $3,022 $126 $3,148

In the three years we would have had that money sitting in the RRSP, we would now have $3148.00. That’s $363 more dollars than we initially put into the RRSP.

If it takes 4 additional months to pay off the debt by only using the tax-return money, vs. depositing one large chunk into our debt, we can see that this is still the better option.

Lump Sum

Month-Year, Month Number, $ Owing, $ Interest, $ Total, $ Payment
Mar-10 30 $1,620 $11 $1,631 $604.00
Apr-10 31 $1,027 $7 $1,033 $604.00
May-10 32 $429 $3 $432
$604.00
Jun-10 33 -$172 $0 -$172 $604.00
Jul-10 34 -$776 $0 -$776 $604.00
Aug-10 35 -$1,380 $0 -$1,380 $604.00
Sep-10 36 -$1,984 $0 -$1,984 $505.37

October 2010 – You will have $0 owing, $2489.00 in the bank (to be invested into an RRSP), and will have paid the least amount of interest in the lifetime of the loan out of the 2 options.

RRSP Tax Return Only

Month-Year, Month Number, $ Owing, $ Interest, $ Total, $ Payment
Mar-10 30 $4,023 26.82216621 $4,050 $604.00
Apr-10 31 $3,446 22.97431398 $3,469 $604.00
May-10 32 $2,865 19.10080941 $2,884 $604.00
Jun-10 33 $2,280 15.20148147 $2,295 $604.00
Jul-10 34 $1,691 11.27615802 $1,703 $604.00
Aug-10 35 $1,099 7.324665737 $1,106 $604.00
Sep-10 36 $502 3.346830175 $505 $505.37

October 2011 – $0 dollars owing, but $3,148 in an RRSP and you would have paid $346.84 dollars more in interest over the lifetime of the loan.

The Winner

Who’s the winner?

OPTION 1 – LUMP SUM

$2489.00

OPTION 2 – RRSP

$3,148 – $346.84 = $2932.16

We’re not quite ready to say yet. By following OPTION 2 of debt repayment, you will have achieved $443.16 more than by using your cheque to buy an RRSP and using the tax rebate. Right? Well, here lies the problem.

The money from OPTION 2 that is sitting in the RRSP is pre-tax, and not post-tax. The money you would be accumulating from the end of repayment in OPTION 1 would be post-tax dollars. This means when you invest that amount, you get additional money back at this point too!

The amount you would receive back would be, again, about 30%, which could be re-invested into RRSPs for the following year. Considering this, let’s take a look at our talley again:

OPTION 1 – LUMP SUM

$2489.00 (Post-tax) is actually worth an additional $746.70 after invested into an RRSP.
$2489 + $746 = $3235 NET

OPTION 2 – RRSP

$3,148 – $346.84 = $2801.16 NET

 

Well, there it is. The benefits of dumping that money into the debt is greater than putting it into an RRSP right now. The difference is $433.84. This is significant. Very significant.

I’m sure there’s many other factors that can influence a decision where the prime motivator would only be $200, but for half a grand, they really can’t stack up.

Benefits of the RRSP is:

  • go back to school
  • buy your first home
  • get old and retire
  • Let’s face it, at the end of 3 years of grueling payments, are you really going to have the motivation to put that remaining money into an RRSP, or are you going to squander it on a new flat-screen TV?

Benefits of the Debt Repayment is:

  • possibility of smaller monthly payments (just in case one month is tough, like the approaching Christmas Season)
  • less visible guilt
  • clearing more room in your line of credit, in case of emergency
  • $433.84 more in your pocket at the end of the 3 years.

What we didn’t tell you.

There’s a few things in here that aren’t exact. Here’s a short list:

  • Return on RRSP. Although you can get a low rate, or a high rate, I estimated 5% as being a good performance with the little risk.
  • Line of credit rate. Pretty much, this is based on a fixed percentage in addition to the prime rate. I guess this number can flux a bit too, but not too much in the 3 year span of repayment.

The numbers I’ve chosen are highly volatile. Any small change to a factor (interest rate, monthly payment, money outstanding) would require an entire recalculation. If you have a calculation you’d like me to perform, please drop me a line at realworldnumbers@rippul.com.

 

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6 Comments leave one →
  1. October 11, 2007 3:18 am

    Wow that is a heck of a lot of numbers! An interesting question you have asked and definitely a detailed analysis. I think if you are shooting for 4.5-5% return on your RRSP that you should be able to count on very little risk(virtually zero) and grow your money a little bit as well.

    I’ll have to stay tuned for more number crunching, you’ve provided a good lesson on the power of compounding interest!

  2. realworldnumbers permalink*
    October 11, 2007 3:18 pm

    tongue in cheek, i’d have to say that i enjoy when my site compounds interest… 😉 Thanks for checking it out!

  3. Stuck in Miami permalink
    October 14, 2007 1:12 am

    Hi there,

    You forgot another option…

    Take the cheque, purchase Apple stock in a self-administered RRSP… and pay off the entire debt in 12 months.

    🙂

    Shoulda, woulda, coulda!

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