Auto Loan Prepayment Penalty Basics

Get Car Financing
Even with poor credit.

By

Automotive Editor

John Diether has been a professional writer, editor, and producer since 1997. His work can be found on TV, radio, web, and various publications throughout the world.  He is a graduate of Northwestern University and has a 1992 Cadillac Brougham d’Elegance in his garage. 


, Automotive Editor - June 10, 2016

In today's financing atmosphere, consumers need to be aware of prepayment penalties on auto loans. There was a time when the length of a loan remained at a comfortable 24 to 36 month period. The loan terms were fairly simple, containing little, if any, added fees, like prepayment penalties. However, traditional loans are now taking the back seat to a variety of creative arrangements, which include terms outlining prepayment penalties. Nationwide, prepayment penalties are allowed in 36 states and the District of Columbia. This discourages buyers from paying the loan off early, and allows the lender to collect all the interest.

Many loans have no penalty for early payment. In fact, many car loans are structured so that you gain an advantage by paying the loan off early. However, since the practice is increasingly common, it's important that you watch for these penalties. You should be particularly vigilant if you have bad credit, are being charged a higher than average interest rate, or are taking out a loan for a large number of years (4 or more). The penalties are less common on loans of 24 to 48 months (2 to 4 years).

Identifying prepayment penalties

There are a couple of different ways a lender imposes a prepayment penalty. One type is very direct, and therefore easy to identify if you are aware of its existence and examine loan documents carefully. These are percentage penalties, in which the borrower is charged a certain percentage of the balance remaining on the loan if he or she pays it off early. The amount of the penalty, therefore, would be lower the longer you've had the loan.

These penalties are allowed in 36 states, although they are prohibited around the U.S. for loans longer than 61 months (over 5 years). These penalties must be disclosed in the loan documents, in accordance with truth in lending practices, so read your loan documents carefully and refuse to sign any loan that includes a prepayment penalty. Watch carefully for any of these phrases in the loan documents: prepayment penalties, pre-computed loan, full amount of interest.

Since percentage prepayment penalties are easy to identify, some lenders use other techniques to accomplish the same purpose, but disguise it as something else. For example, some lenders use the "Rule of 78s", which means that all payments go to pay off the full amount of the interest calculated on the loan before any payments are applied to principal. This ensures that no matter how quickly the loan is paid off, the lender gets the full amount of interest.

Another technique that accomplishes the same purpose is a pre-computed loan. These loans calculate the entire amount of principle and interest into the loan. The borrower agrees to pay the entire amount of principal and interest, regardless of how quickly the loan is repaid. While they are technically not prepayment penalties, these kinds of loans do penalize you by not allowing you to save money by paying off the loan early.

Finding loans without penalties

In order to find loans that don't carry penalties, you need to ask for a simple interest loan. If a dealer or institution is offering any other type of loan, it likely involves the Rule of 78s or pre-computed interest, and is not the loan you want. If you are offered a simple interest loan, read the documents carefully, to make sure there is no prepayment penalty. Remember that you cannot take the word of a loan officer or dealer that there is no penalty.

Many financing arrangements made at the dealer are with manufacturer-owned finance companies, where the entire transaction, including financing, determines the seller's profit. To maximize this profit, most dealer-originated finance deals include prepayment penalties. Check with other financing opportunities to discover agreements that do not include prepayment penalties. low.

If you have poor credit or a poor repayment history, you are more likely to be offered a loan with prepayment penalties or pre-calculated interest, so be especially careful if you fall into that category. Read each page of the documents yourself, and ask a legal expert if you have any questions.

Need a Car Loan?

It only takes a minute.

, Automotive Editor

John Diether has been a professional writer, editor, and producer since 1997. His work can be found on TV, radio, web, and various publications throughout the world.  He is a graduate of Northwestern University and has a 1992 Cadillac Brougham d’Elegance in his garage. 


Search New Cars by Loan Payment »

View estimated loan payments based on local rebates and financing offers.

Loan approval is not guaranteed and is subject to credit application and approval of the lender. Individual loan terms may vary. Use of this website constitutes acceptance of CarsDirect.com's Terms of Use, Disclaimer, Privacy Policy, and Cookie Policy.

Privacy Policy|Terms of Use|Cookie Policy|Disclaimer
COPYRIGHT 1999-2019 MH Sub I, LLC dba CarsDirect.com