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Paying off your loan ahead of schedule is not always the right financial move. Though it’s becoming rarer, many lenders have prepayment penalties, a fee enforced if you pay off your loan early. These fees can prevent you from saving money on interest.
Consider how to work around these additional fees and request changes on how payments are applied.
What a prepayment clause is
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.
Prepayment penalties make it difficult to pay down the principal or refinance with a different lender. And 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. So while refinancing is an option to avoid the costs of paying off your loan early, that choice will still cost you, as there will be fees to get out of your current contract.
Because cars depreciate in value, the more you pay in interest, the more likely you are to be upside-down on your loan.
Only some states allow prepayment penalties. 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
There are two major ways prepayment clauses impact your auto loan.
You may not be able to pay principal down
A prepayment clause may make it impossible to pay the principal down. Instead, that additional amount goes toward your next monthly payment. It can be helpful in a pinch by lowering the total amount you owe month-to-month, but you’ll still end up owing the same amount of interest.
Refinancing is more difficult
A prepayment clause may include a prepayment penalty that could make refinancing more expensive than it’s worth. But provided you’ll save more on interest with a new lender, 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.
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 some lenders don’t have prepayment clauses but still apply additional payments to interest first. Reach out to your lender and request that your money be applied to the principal. If there’s no prepayment clause, your lender has to comply.
The 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.