Auto Loan Prepayment Penalty Basics

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Automotive Content Editor

Meghan Carbary has been writing professionally for nearly 20 years. A published journalist in three states, Meghan honed her skills as a feature writer and sports editor. She has now expanded her skill-set into the automotive industry as a content writer for Auto Credit Express, where she contributes to several automotive and auto finance blogs.


, Automotive Content Editor - September 21, 2021

In today's financing atmosphere, consumers need to be aware of prepayment penalties on loans, though they're not as common as they once were, especially on auto loans.

Nationwide, prepayment penalties are allowed in 36 states and the District of Columbia.

What’s a Prepayment Penalty?

Prepayment penalties discourage buyers from paying their loan off early and allows the lender to collect all the interest. The fees can vary widely, sometimes requiring you to pay off all your interest due regardless of when you repay.

There was a time when the length of a loan remained at a comfortable 24 to 48 month period. Loan terms were fairly simple, containing little, if any, added fees such as prepayment penalties. However, traditional loans are now taking the back seat to a variety of creative arrangements, which include terms outlining prepayment penalties.

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 the average interest rate, or are taking out a loan for a large number of years -- around five or more.

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, per Truth In Lending practices, so read your loan documents carefully. Watch carefully for any of these phrases in the loan documents: prepayment penalties, pre-computed loan, the full amount of interest.

You can refuse to sign any loan that includes a prepayment penalty, and walk away.

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, it used to be common for lenders to 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 the 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 principal 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 most cases, when it comes to car loans, you don't have to ask for a loan without prepayment penalties, since most auto loans these days are simple interest loans. This means that interest is calculated and accrued daily based on the amount of principal you owe.

A simple interest loan is designed to save you money on interest charges if you can pay off the loan early. 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 – if it’s in the documents it’s binding

Many financing arrangements made with manufacturer-owned finance companies are designed where the entire transaction, including financing, determines the seller's profit. To maximize this profit, some dealer-originated finance deals include prepayment penalties.

If you find yourself reading a contract that includes penalties for early payoff, check other financing opportunities to find an agreement that doesn't include prepayment penalties.

There was a time when if you had poor credit or a poor repayment history, you were more likely to be offered a loan with prepayment penalties or pre-calculated interest. Though this practice isn't as common anymore, you still need to 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.

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, Automotive Content Editor

Meghan Carbary has been writing professionally for nearly 20 years. A published journalist in three states, Meghan honed her skills as a feature writer and sports editor. She has now expanded her skill-set into the automotive industry as a content writer for Auto Credit Express, where she contributes to several automotive and auto finance blogs.


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