Prepayment penalties can prevent you from saving money on interest. Many lenders have it — though it is becoming rarer — but you can request changes to how payments are applied. You can also refinance but be prepared to pay a fee to get out of your current contract.
What a prepayment clause is
Prepayment clauses specify how and when a borrower 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. You may be entitled to a partial refund or rebate, but it 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. Cars depreciate in value; the more you pay in interest, the more likely you are to be upside down on your loan.
How prepayment clauses affect auto loans
When you decide to pay a little extra, 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 paying a large amount of interest.
Refinancing also becomes much more difficult with a prepayment clause. There may be 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.
If you are in the market for a loan, discuss prepayment penalties with your lender. You want to be up front. 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.
Follow the same process if you’re looking to refinance. Make sure the prepayment penalty isn’t too high, then compare lenders that don’t enforce a prepayment clause. Once you refinance, you’ll be able to make any extra payments you want.
Negotiating with your current lender is also an option if you don’t want to refinance. You may be able to request extra payments be applied to 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.
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