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Key takeaways
- Prepayment penalties are fees enforced by lenders if a borrower pays off a loan early or makes extra payments.
- These types of fees tend to be most common with auto loans and can often be 2 percent of the remaining loan balance.
- Prepayment penalties can make refinancing your auto loan unwise and make it more challenging to pay down the loan principal.
- It is important to discuss prepayment penalties with your lender before taking out a loan and to compare options with no prepayment clauses.
While paying off your debt as quickly as possible feels like a reason to celebrate, it is not always the right financial move. Some lenders enforce prepayment penalties, a fee enforced if you pay off your loan early. It tends to account for 2 percent of your outstanding balance and requires consideration before making extra loan payments.
Consider how to work around these additional auto loan fees and request changes on how payments are applied.
What is a prepayment clause?
Prepayment clauses are a part of your contract specifying how and when you can pay off a loan. Some may have a prepayment penalty — a fee for paying off a loan early or making extra payments. This is especially common with auto loans that use precomputed interest.
On average, the penalty is about 2 percent of your outstanding balance. So, if you have $7,000 remaining, you would have to pay $140. Fortunately, not all lenders will penalize borrowers, and not all states allow prepayment penalties. In some cases, you may be entitled to a partial refund or rebate, but it likely won’t cover the full amount of interest you paid.
Only some states allow these fees
In 36 states and Washington D.C., lenders can charge prepayment penalties on loans with a term of 60 or fewer months. Federal law prevents lenders from charging prepayment penalties on loans with longer terms.
How prepayment clauses affect auto loans
Prepayment clauses impact your auto loan in two primary ways: you may not be able to pay the principal down faster and refinancing will be more difficult.
First, a prepayment clause may make it difficult to pay more of the principal down than you would on a normal payment. Instead, that additional amount goes toward your next monthly payment. And because cars depreciate in value, the more you pay in interest, the more likely you are to be upside down on your loan.
If your loan has a high interest rate, you’ll end up paying a significant amount to your lender without being able to reduce the principal.
Bankrate tip
Outside of checking for any fees enforced for paying off your loan early, calculate potential interest savings to see if it’s worth it.
Another time that a prepayment clause might prove to be a challenge is when refinancing. You might consider refinancing with a different lender to save some money. But if penalties are enforced, it can cost you more.
Before comparing auto loan refinancing rates, confirm that you will, in fact, save more interest with a new lender and you may still manage to break even.
How to avoid auto loan prepayment penalties
It is possible to avoid prepayment penalties on your auto loan. But the exact process of avoiding them depends on what you’re trying to accomplish.
If you are in the market for a loan
Discuss prepayment penalties with your lender. You want to be upfront. Plenty of lenders — including banks and credit unions — don’t have prepayment clauses in their contracts. You can avoid a lot of future headaches by ensuring this before you take out a loan.
The best auto loan depends on your specific needs, and if you intend to pay off your loan early, look for lenders that will not penalize you for it. LightStream, for example, enforces no fees and offers a wide range of financing amounts — for both refinancing and vehicle purchases.
If you’re looking to refinance
Follow the same process when comparing new lenders. Compare options that don’t enforce a prepayment clause. Once you refinance, you’ll be able to make any extra payments you want.
But consider the costs of refinancing if your current loan has a prepayment penalty. Use an auto loan refinance calculator to see if it makes sense for your budget. Calculate the fee as part of your new loan amount to determine if it’s worth refinancing.
If you’re happy with your loan
Negotiating with your current lender is also an option if you don’t want to refinance. You may request extra payments be applied to the principal even if you have a prepayment clause. But this is far from guaranteed. Most lenders won’t modify a loan contract without good reason.
Keep in mind that some lenders don’t have prepayment clauses but still apply additional payments to interest first. If this is the case, contact your lender and request that your money be applied to the principal. If there’s no prepayment clause, your lender has to comply.
Bottom line
Not all states allow prepayment penalties — and no lender can charge one on a loan term over 60 months. But if your contract already has one, there are ways to work around it.
Start by getting in touch with your lender and asking for payments to be applied differently. If that doesn’t work, consider refinancing. Even with a prepayment penalty, you may be able to save money on interest over the life of your auto loan.
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