Auto Loan Prepayment Clauses: Avoid Paying More

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While paying off your debt as quickly as possible feels like a reason to celebrate, it’s not always the right financial move. Some lenders charge prepayment penalties, a fee assessed if you pay off your loan early. It typically accounts for 2 percent of your outstanding balance, so consider how to work around these fees or request changes to how payments are applied.

What is a prepayment clause?

Prepayment clauses are a part of your contract that specify 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.

The penalty is, on average, about 2 percent of your outstanding balance. Fortunately, not all lenders 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.

How prepayment clauses affect auto loans

Prepayment clauses impact your auto loan in two primary ways:

• A prepayment clause may make it more difficult to pay the down principal because that additional amount goes toward your next monthly payment instead. Since cars depreciate in value, the more you pay in interest, the more likely you are to be upside down on your loan.
• Prepayment penalties may also prove challenging during refinancing. You may want to consider refinancing with a different lender to save money, but if your current lender charges you a fee for early payment, you could lose out on potential savings.

How to avoid auto loan prepayment penalties

It is possible to avoid prepayment penalties on your auto loan. But the exact process of avoiding this fee depends on what you’re trying to accomplish.

If you’re 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 many future headaches by ensuring this before taking 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 won’t penalize you for it. LightStream, for example, doesn’t charge any fees and offers a wide range of loan 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 whether refinancing is worthwhile.

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 that 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.

Begin by contacting your lender and requesting that payments 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.