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What Is a Prepayment Penalty on a Car Loan?

  • Auto Refinance
  • Renee Martin
  • 6 minutes

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Wary of closing your loan early because of those pesky hidden fees? Auto loan prepayment penalties often cost the most – here’s all you need to know about it.

So you’ve done an audit of your finances and realize that you don’t really need to keep paying high amounts on that pending auto loan. With the way gas prices are rising and the spiking costs of new and used vehicles, you think it’s best to close the loan early with some cash you have in hand. All goes well – until you realize the lender has charged you with an additional amount as a ‘prepayment penalty’ on the auto loan!

Such ‘hidden’ fees and charges can often play havoc with even the best-laid plans to close a loan. That’s why we’ve put together this quick explainer for you!

What is an auto loan prepayment penalty

What Is a Car Loan Prepayment Penalty?

A prepayment penalty is a fee charged by lenders for closing a loan early or before the scheduled due date. Typically, when borrowing an amount for an auto loan, you will likely choose a loan term between 24-60 months. The lender receives interest as long as you keep paying car loan monthly payments on the loan.

However, if you choose to pay back the loan before the due date, the lender may stand to lose all the interest they hoped to accrue during the remaining term. To offset that, they may charge you a prepayment penalty.

Why Would You Want to Close a Car Loan Early?

You may want to close an auto loan early for the following reasons:

  • If you are paying a bad car loan with a high APR and don’t want to continue with high monthly amounts
  • If you think you can save more by closing the loan today rather than accumulate interest in the principal
  • When you want to refinance the auto loan to a lower APR and get more affordable monthly payments
  • When you want to improve your debt-to-income ratio
  • If you want to remove the lender as lienholder and own the vehicle title yourself

Why Do Lenders Charge Prepayment Penalties?

You’d reckon that lenders would be happy to receive their money back before the scheduled date and that they would look favorably on borrowers closing a loan early! However, the way lenders make money is through the interest accumulated on the remaining loan balance after every monthly payment.

Every payment you make goes towards repaying part of the principal and interest. So when you decide to pay off the loan in one go, you’re essentially reducing the amount of money they make from the interest! Auto loan prepayment penalties are a way for lenders to discourage borrowers from closing loans early and to offset the ‘lost’ interest if they do so.

When Do Lenders Charge Prepayment Penalties on Auto Loans?

Prepayment penalties vary in amount and point of implementation depending on the lender. Some lenders will charge you a penalty if you close the loan at any point before the due date. However, others specify that you’ll be penalized only if you pay off the loan early within a certain timeframe – for example, within the first six months.

How Much Will an Auto Loan Prepayment Penalty Cost?

Typically, an auto lender can charge you up to 2% of the remaining loan balance as a prepayment penalty. That means if you still owe $10,000 on your loan when you decide to close it, you will have to pay $200 as a prepayment penalty.
The exact amount might vary in different states where state laws have capped the maximum chargeable prepayment penalty.

Are Prepayment Penalties on Auto Loans Legal?

There is no federal law in place that bans auto lenders from charging prepayment penalties. However, certain states have enacted laws that prohibit state-run banks and institutions from imposing prepayment penalties on borrowers (like Maine, Massachusetts, and Nevada). This also means that private lenders can still charge you an amount for early auto loan closure.

How Do I Check for a Prepayment Penalty Clause in My Auto Loan?

According to the Truth In Lending Act (TILA), all lenders should provide full disclosure of all terms and costs associated with the loan. However, lenders may use different terms to indicate prepayment penalties or discourage you from early closure. This includes:

  • Rule of 78: Requires borrower to pay a greater part of the interest in the earlier part of the loan term
  • Percentage Penalties: You will have to pay a certain percentage of your loan balance as early closing charges
  • Precomputed Loans: You will have to pay interest on the principal at the start of the loan, and not simple interest on the remaining loan balance

How to Avoid Prepayment Penalties

Think that the prepayment penalty will do you more harm than good? You can dodge spiraling costs in the following ways:

  1. Refinance the auto loan with a lender that does not have penalties: Auto loan refinancing can help you score a lower APR and get lower monthly payments with affordable lenders who won’t charge you penalties.
  2. Pay the loan according to schedule: If the penalty is more than the savings in interest, it does not make sense to close the loan early. You might as well continue paying amounts according to the set schedule.
  3. Pay off a portion of the loan: Ask your lender how much you can pay off without having to pay a penalty, and make a payment towards that
  4. Check the loan agreement when you first sign it: Prevention is better than cure – see if your lender mentioned prepayment penalties and how they calculate them in the loan contract. That way, you can avoid bad deals.
  5. Choose no-penalty auto loans: Many lenders will not charge for early loan closure
  6. Negotiate with the lender: Your lender may allow you to make extra payments to the principal, allowing you to reduce the loan balance faster.

Also read: How to Pay Off Your Car Loan Faster

Frequently Asked Questions (FAQs)

What Types of Loans Have Prepayment Penalties?

While home mortgage loans are more likely to have prepayment penalties, auto loans and personal loans can also have charges for early closure. Such penalties are more common with bad credit loans, sub-prime car loan lenders, and buy-here, pay-here dealerships.

How Are Prepayment Penalties Calculated?

Prepayment penalties can be calculated as:

  • A percentage of the remaining loan balance
  • A flat fee based on when you choose to close the loan; or
  • Using a certain formula disclosed in the loan agreement

Are Prepayment Penalties Common?

Prepayment penalties are common for mortgage home loans but less common for personal and auto loans. However, it varies from state to state.

Can You Pay off a 72-Month Car Loan Early?

Yes, you can pay off a 72-month car loan early if your lender does not charge you too much as a prepayment penalty.

What is an auto loan prepayment penalty

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