In today's financing atmosphere auto buying consumers need to understand a car loan prepayment penalty. 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 backseat 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.
Does Every Loan Have Prepayment Penalties?
The simple answer to this question is no. 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, which charge the borrower a certain percentage of the balance remaining on the loan if the borrower pays the loan 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.
Hidden Penalties
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 78's", 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 paying off the loan earlier.
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 78's 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.
Shop Around
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.
If All Else Fails
Try this method: If you have saved or acquired a sizable sum that you would like to use for paying off your car loan, ask your lender for your payout amount. For example, if your prepayment penalty is set at 1 percent of the loan's remaining balance of $10,000, the payout amount would be $10,100. However, don't make a lump sum payment. Instead, tell you lender you want to make a principle only payment of $9,999. Find out how long the payment will take until it is posted to your account. Once posted, ask for a payout calculation from your lender. The new balance upon which your payout calculation is made will be the remaining 1-dollar balance, plus any unpaid interest. Therefore, your prepayment penalty of 1 percent will be extremely 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.
