Prepayment penalties can prevent you from saving money on interest. Many lenders have this – although it’s becoming rarer – but you can request changes to how payments are applied. You can also refinance, but be prepared to pay fees to get out of your current contract.
What is a prepayment clause
Prepayment clauses specify how and when a borrower can repay a loan. Some may have a prepayment penalty – a fee for prepaying a loan or making additional payments. This is especially common with auto loans that use pre-calculated interest. You may be entitled to a partial refund or rebate, but this will not cover the full amount of interest you paid.
Prepayment penalties make it difficult to repay principal or refinance with another lender. And if your loan has a high interest rate, you will end up paying a large amount to your lender without being able to reduce the principal. Cars lose value; the more interest you pay, the more likely you are to be upside down on your loan.
How Prepayment Clauses Affect Auto Loans
There are two main ways prepayment clauses impact your car loan.
When you decide to pay a little extra, a prepayment clause may make it impossible to repay the principal. Instead, that extra amount goes toward your next monthly payment. This can be helpful in a pinch by reducing the total amount you owe from month to month, but you’ll still end up paying a hefty 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 save more on interest with a new lender, you can still manage to break even.
How to avoid car loan prepayment penalties
If you’re looking for a loan, discuss prepayment penalties with your lender. You want to be in front. Many lenders, including banks and credit unions, do not have prepayment clauses in their contracts. You can avoid many future headaches by making sure of this before taking out a loan.
Follow the same process if you are looking to refinance. Make sure the prepayment penalty isn’t too high, then compare lenders that don’t have a prepayment clause. Once you refinance, you’ll be able to make any additional 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 that additional payments be applied to the principal even if you have a prepayment clause. But that’s far from guaranteed. Most lenders won’t change a loan agreement without a good reason.
Keep in mind that some lenders don’t have prepayment clauses, but still apply additional interest-first payments. Contact your lender and request that your money be applied to the principal. If there is no prepayment clause, your lender must comply.
The bottom line
Not all states allow prepayment penalties — and no lender can charge one on a loan term longer than 60 months. But if your contract already has one, there are ways around it. Start by contacting your lender and asking for the payments to be applied differently.
If that doesn’t work, consider refinancing. Even with a prepayment penalty, you may still be able to save money on interest over the life of your car loan.