Why Some Auto Loans Have Prepayment Penalties

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, - May 27, 2016

Some auto loans have what are known as prepayment penalties attached to the contract as a provision. If this is the case for your auto loan, you would be wise to know for sure. If you don’t already know, you can find out by reading through your loan contract. It may be shrouded in jargon but if there is a penalty clause, you will be able to find it.

Lenders make their money on the interest of a loan. They lend you an amount known as the principal. As the time goes by, interest accrues on that amount which represents the lender’s profit. If you were to pay off your principal sooner than they anticipate, they lose out on interest charges, making the loan less profitable for them. For better or for worse, some lenders include penalties in contracts should you attempt to do this.

There are a number of different ways to penalize borrowers for attempting to pay back their loans early. Here are a couple of the most common ones.

Front Loading Interest and the Rule of 78s

What many lenders do to give customers incentives against prepayment is to put all payments toward interest first, before applying later payments to principal. In some kinds of setups, this erases the potential benefits of prepayment. Lenders sometimes use something called the rule of 78s to set up loan agreements where prepayment has a hidden penalty.

The “rule of 78s” is a complex type of loan amortization schedule that is not commonly understood outside of banking circles. If a consumer can break down this idea, they are more likely to be able to benefit from thorough knowledge of modern lending practices.

Another type of contract requires you to agree to pay all of the interest and principal, regardless of how fast you pay the loan off.

Percentage Agreement

This type of penalty is more obvious. It forces you to pay a percentage of whatever balance remains–or would have remained if you had not paid it off.

If you pay the loan off early, you will find yourself responsible for a penalty that is typically 1% of the remaining principal balance. Sometimes there is also a minimum prepayment penalty, between $200 and $300 that is assessed.

One fact that helps car buyers is that prepayment penalties are only legal in 36 of the 50 United States. Some state governments are more proactive than others in offering this kind of consumer advocacy. Make sure to explore all non-penal prepayment possibilities with different lenders.

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