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Personal Loan Question

3304 Views 4 Replies 4 Participants Last post by  Max
I am planning to pay down on my car loan, however I am not quite sure if I would save $$ with that. I understand that with mortgage, when you pay a lump sum payment, you are paying down on your principal, which in turn will cost you less interest and therefore you can pay off your mortgage faster. Does the same theory applies to personal loan as well?
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Yes under most (if not all) loan agreements, you can pay your debt down faster and ultimately save money. Paying off debt is often one of the best "investments" you can make because the rate charged is usually higher than you could easily achieve with investment products and the benefit of paying down the loan is tax free.
It depends. Some automobile manufacturer loans only reduce the interest if you pay them out in full. Additional payments do not reduce your interest cost, since they charged that up front as a finance fee.

They will rebate the interest if you pay in full.

Bank auto loans on the other hand will indeed reduce you interest if you pay extra.
Thanks for your response! In my case, my car loan is actually done through a bank, and after carefully looking at the numbers, it seems like I will be saving a bit by paying off the loan, so I will be doing so in the near future! =)
I discovered recently that all mortgages in Canada are actually compounded semi-annually. Read your mortgage contract to verify this. Most other debt is compounded on a more frequent basis. If you have a choice to pay down a mortgage or another loan of equal interest rate, I think you should choose to pay down the other loans first.

But as Spidey has mentioned, you should always compare the rate of the loan with your best guess of what you could reasonably earn after tax on investments to see whether it is a good idea to pay down the loan.

If your situation allows for more risk tolerance and you have a low rate on your loan, it may not make sense to pay off a loan at 4% when you can reasonably expect to earn 8% (8% - 30% tax = 5.6%) investing that same money in stocks. However, your expectation of what you can reasonably earn off of stocks may be lower and your tax rate may be higher.

If you have empty TFSA room though, the argument to invest the money you had earmarked for a loan repayment becomes much more compelling. While the interest rates stay low, you invest, and when they rise, you sell the investments and transfer the cash to repay the loan, which should end up paying off the loan faster than if you had just paid the money directly against the loan.

In certain cases, it may even be advantageous to reduce your loan payments to invest if you ever end up in the fortunate situation of having an after tax rate of return on investments that clearly exceeds the rate of your loan. However, since this is effectively leveraged investing, you should consider carefully the guaranteed rate of return from prepaying the loan vs. risks in the stock market.
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