What is a Prepayment Penalty on Your Car Loan?
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- Prepayment penalties
- Prepayment legality
- Related clauses
If you pay off your loan ahead of schedule, you might be subject to sneaky fees called prepayment penalties.
At first glance, paying off a long-term fixed loan early may seem like a no-brainer—so a prepayment penalty can come as a bit of a surprise. While most auto loans don’t typically add prepayment penalties, it’s becoming more common.
There are often benefits to paying off your car loan early. You can reduce your debt-to-income ratio, save money on interest, and remove the lender as a lienholder from your car’s title, making it easier to insure, gift, or resell.
You can also save money on your car insurance by having your vehicle paid off.
So don’t be discouraged by the possibility of prepayment penalties. They’re still fairly uncommon, and in some states they’re even illegal. And if you do have prepayment penalties on your auto loan, you can still save money by using Jerry to compare dozens of different insurance companies to find you a lower rate.
Here’s everything you need to know about a prepayment penalty on car loans.
How to spot prepayment penalties
Your lender might charge you a prepayment penalty since they’ll receive less interest from you.
When lenders outline the terms of your loan and the borrowing period, they charge borrowers a certain amount of interest per month on top of the agreed loan payment. Lenders profit from that interest—so the longer a loan is being paid off, the more interest lenders collect.
A prepayment penalty essentially compensates the lender for the reduced interest when you pay off your loan early.
When talking to a lender about an auto loan, make sure you go over your contract and look for any unfamiliar jargon or unclear terms. Lenders will use terms like “rule of 78s” to disguise prepayment penalties in their terms if they don’t outright refer to them as such.
One term in particular that lenders like to use is “percentage penalties”. You’ll get hit with this penalty if you pay off the loan early. It’s calculated as a percentage of your loan balance before you pay off the remainder. So the longer you carry the loan, the lower the amount of the penalty.
Another one to look out for is “precomputed loans”. These loans calculate the total interest and principal that the borrower has to pay, regardless of whether or not you pay the loan early. While precomputed loans are not technically a prepayment penalty, the same principle applies.
Key Takeaway Review your contract before you sign, looking for terms like “rule of 78s,” “percentage penalties,” and “precomputed loans.”
Are prepayment penalties legal?
Yes and no. Although they’re considered risky by the Consumer Financial Protection Bureau, there are no laws in place outright banning the penalties at the federal level. The Bureau has instead implemented policies to restrict how much lenders can charge for these penalties.
At the state level, prepayment penalties can be illegal. Several states have banned the practice—but the ban only extends to banks that are state-run. Banks that are federally run have different rules and can still charge prepayment penalties.
Look for prepayment penalty clauses on your existing loans
If you already have an auto loan that you’re planning on paying off ahead of schedule, and you’re worried about prepayment penalty clauses, the first thing you should do is go over the agreement again.
Look for any reference to prepayment penalties, precomputed loans, percentage penalties, or any unclear jargon.
Because auto loans aren’t commonly subjected to prepayment penalties, you’re likely in the clear. But if you’re one of the unlucky few, call your lender and find out how much you’d owe if you paid the loan off early.
If the penalty is higher than the interest you would be paying otherwise, ask if refinancing is a viable option.
Key Takeaway If your existing loan agreement mentions prepayment penalties, talk to your lender to figure out your options. You may be able to refinance.
If you’ve managed to avoid prepayment penalties and want to save some extra cash to pay your car loan off early, or if you’re looking to reduce your car-related costs until the loan is paid off, Jerry has your back.
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Do car loans typically have prepayment penalties?
The good news is that prepayment penalties are not as common on auto loans as they are for mortgages, but that doesn’t mean it never happens. And even though these penalties are illegal in some states, federally-backed banks can still implement them.
Make sure you ask about or look for prepayment penalty clauses in your loan terms before you sign.
Can you be penalized for paying off a car loan early?
If there are no prepayment penalties on your loan, then there are no other penalties.
In fact, there are benefits to paying off a car loan early—improving your debt-to-income ratio, saving money on interest, and taking full ownership of your car, to name a few big ones.
But if there are prepayment penalties on your loan, you will be penalized for paying the loan off early. You’ll be forced to pay a fee that may be more than the interest you would’ve otherwise paid to your lender.
Be sure to double-check your loan to ensure there aren’t any prepayment penalties before attempting to pay the loan off early.
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