Making Cents of Car Loan Prepayment Penalties

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by Daniel Mattia

Prepayment penalties can discourage borrowers from paying off an auto loan early.

When you take out a new car loan, you agree to pay it back in full by the end of the loan term. But what if you paid more than the minimum payment each month or threw a big chunk of change (like an insurance payout or tax refund) to try to pay off the loan early?

In most cases, paying off your debt ahead of schedule isn’t a problem. In fact, you can potentially save a lot of money.

However, sometimes it can cost you. Why? Some auto loans include a prepayment penalty for paying off your loan earlier than agreed upon.

Fortunately, there are some ways to avoid or overcome loans that include prepayment penalties.

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What Is a Prepayment Penalty?

An auto loan prepayment penalty is a contract clause that stipulates a penalty or fee for paying off some or all of your loan amount early. Prepayment penalties help finance companies offset profits from lost interest payments when a loan is paid off early.

In other words, because the financial institution is effectively “shorted” some of its expected earnings via lost interest, it recoups some of that loss by penalizing you for an early loan payoff.

How Car Loan Interest Works

Car loans are amortizing, which means both the loan’s principal and its accumulated interest are paid off over the entire course of the loan’s term, with a larger portion of each payment directed toward the principal. In the term’s final month, both principal and interest balances are reduced to zero.

With most loans, payments made beyond the minimum payment apply the entirety of the excess payment toward the principal. Thus, paying more than the minimum means you’ll pay less interest over the life of the loan and pay off the loan sooner.

Consider an example car loan:

  • Principal loan balance: $20,000
  • Interest rate: 4%
  • Loan term: 48 months
  • Monthly payment: $451.58

Over the life of this loan, you would pay a total of $1,675.84 in interest over 48 months.

But what if you were to pay an extra $48.42 per month, for a total monthly payment of $500? You’d cut off four months from your loan term, saving a total of $173.64. Not a whole lot, of course, but you free yourself from a bill that much sooner.

Simple interest vs. precomputed interest

Typically, car loans amortize by using simple interest, which means interest is computed based on the loan’s daily remaining balance. Each payment you make gradually reduces the total interest you owe. By making payments over the minimum, you can make a bigger dent in the loan principal and pay less interest over the life of the loan.

In contrast, precomputed loans calculate interest when you first take out the loan. With a precomputed auto loan, the lender guarantees they’ll receive the full amount of interest. Even if you pay off the precomputed loan early, your savings will not be the same vs. paying off a simple interest loan ahead of schedule.

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How Do I Know If My Loan Has a Prepayment Penalty?

The language in your specific auto loan contract specifies whether or not you’ll be subject to a prepayment penalty. The Truth in Lending Act (TILA), a Federal law, also requires lenders to provide you with a Truth in Lending disclosure that will tell you if your loan includes prepayment penalties, among other information.

You could also simply ask your lender or dealership if the loan includes a prepayment penalty, but be sure to verify their answer by looking over your contract yourself.

Precomputed loans and the rule of 78

Though most loan contracts that contain prepayment penalty clauses spell it out explicitly, loans calculated using precomputed interest can penalize you in similar ways.

Some lenders apply the rule of 78 to precomputed loans, assigning a heavier “weight” to the earlier part of its term. By paying off such a loan early, you’ll likely pay slightly more interest than paying off a simple interest loan.

How common are prepayment penalties for car loans?

Prepayment penalties are rarely included in loan contracts offered by banks, credit unions, and other types of lenders. They are more ubiquitous in contracts offered by buy-here, pay-here dealerships or in subprime auto loans offered to borrowers with bad credit, but there isn’t anything stopping you from shopping around to find a better loan if you plan on paying it off early.

When Are Prepayment Penalties Charged?

Exactly when a prepayment penalty is charged depends on the specifics of your auto loan contract. Some prepayment clauses specify that charges are assessed if you pay off your loan early at any point in the term. Other contracts specify that prepayment penalties are charged only if you pay off the loan early within a given timeframe, i.e. within the first six months.

If you plan to make monthly payments over the minimum, pay special attention to where that money goes. Some lenders will apply extra payments toward the interest portion of your loan first. To combat this, ensure your extra payments are principal-only.

How Prepayment Penalties Are Calculated

How prepayment penalties are calculated are also dependent on your specific auto loan contract. Penalties for an early loan payoff may be:

  • A flat fee, with or without an expiration date (for example, $350 for an early payoff within the first half of the loan term and $0 in the second half);
  • A percentage of the remaining loan balance;
  • Or, less frequently, the entire remaining balance, including both principal and interest.

If your auto loan contains a prepayment penalty clause, consult your TILA documentation to determine how your lender assesses charges. For some loans with particularly harsh calculations, you may simply be better off paying your loan off on-time as opposed to early.

The Legality of Prepayment Penalties for Car Loans

Whether or not a prepayment penalty clause can be added to your auto loan contract depends on your state’s laws. However, federal regulations restrict prepayment penalties, particularly in regards to the rule of 78, outlawing its use for loans with terms greater than 61 months.

Individual state laws may further limit, or outlaw entirely, the rule of 78 as it relates to car loans. Before taking out a loan, it’s wise to consult your state’s laws or Attorney General’s office to determine what is or isn’t allowed as it relates to prepayment penalties.

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3 Ways to Deal With Prepayment Penalties

Time is the best teacher, and you shouldn’t be punished for taking out a car loan with prepayment penalties before learning what they were and how they operated.

It’s also likely your finances and income have changed since taking out your most recent car loan, so you shouldn’t be stuck paying prepayment charges if you intend on being a responsible borrower who wants to pay off your loan early.

Fortunately, you’re not without options. Though you can’t remove a prepayment clause from an existing loan contract once you’ve signed it, there are ways around it.

1. Negotiate

Contracts are negotiable, and auto loans are no different. You’re not just restricted to negotiating the sales price of the car you want to buy, either. You can negotiate the loan’s APR and interest rate, term, fees, and undesirable clauses — like prepayment penalties.

This means familiarizing yourself with the contract you’re being offered. Read over the TILA disclosures, policy details, and fine print to make note of changes you’d like made to the contract.

Negotiate better loan terms before signing something you’ll be responsible for paying for the foreseeable future. If the lender isn’t open to removing objectionable terms like a prepayment clause, shop around for better offers or come prepared with a preapproved loan from a lender of your choice.

2. Deal with the charges

It doesn’t always feel good to be told to “deal with it,” but sometimes, that’s exactly the right choice to make. Of course, you might have to do a little bit of math to figure out if eating the penalty makes sense for you — or will just leave you with a sour stomach.

Grab your trusty calculator or refer to an online tool to figure out how much interest you’d save by paying off your loan early. Compare those potential savings to the total prepayment penalty you’d be on the hook for.

Early Payoff Auto Loan Calculator

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Increasing your monthly payment by $0 will save you $0 in interest and you will pay off your loan 0 months sooner!

If you’ll save more than you’ll pay in charges, go on and pay off your loan or make greater-than-minimum monthly payments (just make sure the excess is applied principal-only).

If the potential savings aren’t worth it, or you wouldn’t be saving anything at all, focus on paying down your other expenses to boost your credit. Alternatively, save up for a down payment for a future car purchase to reduce or totally eliminate another loan obligation.

3. Refinance

Just because you take out a loan to finance a car purchase doesn’t mean you’re stuck with it forever. Refinancing an auto loan can replace your existing loan with one that has more agreeable terms, like the lack of prepayment penalties.

Depending on your credit score, you may even be able to refinance to a loan with a lower interest rate. Bear in mind that you may still have to pay a prepayment penalty when refinancing a loan that includes one. However, your new lender may permit you to wrap those charges into the new loan.

Do your research and shop around to see what loans are available to you and your situation. Your savings from refinancing to a loan with a lower interest rate may outweigh the prepayment penalty of your previous loan, particularly if you intend on making monthly payments beyond the minimum instead of paying off the loan in one fell swoop.

Should I Pay Off My Car Loan Early?

In most cases, paying off your loan early makes sense. Even if you end up paying a prepayment penalty, you may end up saving more on interest charges than you pay in fees. Paying off your loan early can quickly build positive equity, improve your credit, and keep more cash in your pocket.

That is, of course, considering you even find a loan with a prepayment penalty. Considering the rarity of including such a clause, you may not have any reason to worry whatsoever. Still, read over your loan documentation before throwing some extra cash at your car payment.

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