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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.
Bankrate tip
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.
FAQs
Negotiate To Remove The Prepayment Clause
You can always try to negotiate having it removed from the contract; ask your lender if they will waive the fee. If they agree, make sure you have it in writing. You can also ask your lender for a quote without the penalty, but remember, that might increase your interest rate.
What is the 5 4 3 2 1 prepayment penalty? ›
A 5-4-3-2-1 prepayment penalty, otherwise known as a 5 year stepdown prepayment penalty, charges a 5% fee on the outstanding principal loan balance if the loan is paid off in year 1, a 4% fee in year 2, a 3% fee in year 3, a 2% fee in year 4, and a 1% fee in year 5.
What are the rules for prepayment of car loan? ›
Some banks do not allow prepayment of car loan for at least a year after the loan is availed. Once you are clear about all the foreclosure clauses, contact the bank directly. You may be asked to fill in a form for foreclosure. The penalty fee (if any) can be paid through ECS, cheque, drafts and also NEFT.
What states don't allow prepayment penalties? ›
Most states allow lenders to impose a fee if borrowers pay off mortgages before a specific date – typically in the first three years after taking out a mortgage. While Alaska, Virginia, Iowa, Maryland, New Mexico, and Vermont have banned prepayment penalties, other states allow them with certain conditions.
How to avoid prepayment penalty? ›
They can also choose not to charge this fee on conventional loans, so it makes sense to take out a loan from a lender that doesn't impose the penalty. Another way to avoid prepayment penalties is by holding off on refinancing or selling your home until the prepayment penalty period — usually three years — has passed.
Are prepayment clauses enforceable? ›
To be enforceable, prepayment premium provisions should: (1) make clear that the borrower is obligated to pay in the event of default and acceleration; (2) state that damages for early termination are not easily ascertainable, and (3) make clear that the provision is intended to compensate the lender for the actual ...
What is the no penalty clause for prepayment? ›
Borrower shall have the right to prepay the full amount of any unpaid principal and accrued interest due under this Agreement, at any time without any penalty.
What is abusive prepayment penalty? ›
An abusive prepayment penalty typically is effective more than three years and/or costs more than six months' interest. Steering and Targeting: Even when you can qualify for a mainstream loan, predatory lenders may steer you into subprime mortgages.
What is the 3% prepayment penalty? ›
This fee is typically structured as a percentage of the remaining loan balance. For example, a loan might have a fixed prepayment penalty of 3%. In this situation, the borrower would have to pay back the remaining balance plus 3% of the same if they wanted to pay off the loan in full.
Can you pay off a 72 month car loan early? ›
There are no legal restrictions to paying off your auto loan early but it may come with fees from your auto loan provider. Paying off a car loan early can be a good option to save money and reduce your debt, but whether it is a good idea depends on your unique financial situation.
The Borrower may prepay this Loan in part or in full at any time. Such prepayment shall be without premium or penalty; provided, however, that the foregoing shall in no way limit accruing interest charges for an Event of Default, advances, expenses or late fees.
What is an example of a prepayment penalty clause? ›
A homeowner decides to refinance a two-year-old mortgage with a remaining balance of $250,000. If there is a prepayment penalty of 4%, said homeowner would pay $10,000 to the original lender for paying off the mortgage early.
Can you prepay a car loan without penalty? ›
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.
What is the mandatory prepayment clause? ›
A provision in loan agreements and other debt instruments that requires a borrower to prepay a portion of their debt upon the occurrence of certain events. Lenders may require prepayments of their loans with net cash proceeds received by the borrower from various sources including, most typically: Asset dispositions.
How do I know if my auto loan has a prepayment penalty? ›
Checking for a prepayment penalty in an existing contract
If you already have an auto loan that you'd like to pay off early, check your contract to see whether it contains a prepayment penalty clause. You can also check your state law to see whether it's prohibited.
Is it legal for a lender to charge a prepayment penalty? ›
For many kinds of new mortgages, the lender can't charge a prepayment penalty—a charge for paying off your mortgage early. If your lender can charge a prepayment penalty, it can only do so for the first three years of your loan and the amount of the penalty is capped.
What is the average prepayment penalty for a mortgage? ›
How much are prepayment penalties? Mortgage loans with an early payment penalty are rare today, but when applicable, the fee can be steep. The penalty can be 2 percent of your loan balance within the loan's first two years and 1 percent of your loan balance in year three.
What is the justification for prepayment penalties? ›
Prepayment penalties are written into mortgage contracts by lenders to compensate for prepayment risk, particularly in difficult economic climates and under circ*mstances where the incentive for a borrower to refinance a subprime mortgage is high.
Can you negotiate a repayment plan? ›
Repayment plan negotiation can be very beneficial in that it can relieve financial pressure. Although it is not required, it is strongly recommended that you work with a lawyer when pursuing repayment plan negotiation.
