What's so bad about debt?

National Post

2010-02-26


You may be able to deduct interest payments

Is debt always a four-letter word? The answer depends on the purpose of the debt, the interest rate and whether or not the interest paid on the debt is tax deductible.

Borrowing to invest in an appreciating asset can make financial sense if the expected rate of return on the asset purchased has a good likelihood of exceeding the interest paid on the loan. Consumer debt, used most often to purchase depreciating assets, may not be the most prudent use of credit.

The interest rate you pay is also a critical factor, with lower rates generally available on both mortgages and secured lines of credit versus the higher rates of credit cards.

Finally, whether or not you can deduct the interest on your loan for tax purposes plays a huge role in deciding how advantageous debt can be.

The general rule is that if you borrow money to earn income, either from investments or from a business, the interest paid on that loan is deductible. But if you borrow for personal consumption, including getting a mortgage to finance the purchase of your home, that loan interest is not deductible.

How do you decide whether you should get that RRSP catchup loan before Monday's 2009 RRSP deadline? The theory behind borrowing to invest is based on the fact that you have unused contribution room available and no other source of funds for a contribution before the March 1 deadline.

If you have any funds or investments outside an RRSP, you may consider making an "in-kind" RRSP contribution to your RRSP before borrowing the necessary shortfall.

Unlike a traditional nonregistered investment loan, the interest paid on an RRSP loan is not tax deductible. The expected rate of return you are hoping to get on the investment inside your RRSP must generally be well above the non-deductible interest rate you are paying on the loan for the strategy to make sense.

Given the non-deductible nature of the interest, it also helps if you can repay the loan as quickly as possible to minimize the interest paid.

Where RRSP loans can really make sense is if you were in a high tax bracket in 2009 and in a much lower bracket this year or will be in future years. Borrowing to invest in that RRSP now to get a deduction for 2009 at a high rate could outweigh the cost of any nondeductible interest paid.