Avoiding Prepayment Penalties For Car Loans

Avoiding Prepayment Penalties For Car Loans


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When shopping for a vehicle there are a many different types of loans to choose from. It is important to investigate the terms carefully to avoid prepayment penalties for car loans should you wish to pay off your loan early. What Are Prepayment Penalties A prepayment penalty is a fee charged by the lender if […]




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When shopping for a vehicle there are a many different types of loans to choose from. It is important to investigate the terms carefully to avoid prepayment penalties for car loans should you wish to pay off your loan early.

What Are Prepayment Penalties

A prepayment penalty is a fee charged by the lender if you choose to pay off your loan ahead of time or refinance your current loan. The amount you will be penalized will be included in your loan contract.

Why Do Lenders Charge Early Payoff Penalties

Lenders make money on the interested accrued over the life of a loan. This penalty was instituted so lenders can recuperate costs related to the loan. Paying off a loan early means less money for the lender; refinancing means less money for the lender. Penalizing borrowers who wish to get out of a loan sooner than agreed upon is one way get back some of the interest or profit from the borrower.

How Much is the Prepayment Penalty

There are three common ways prepayment penalties are imposed. The first is when the borrower agrees to repay the total interest and principle of the entire loan. A fee is computed into the loan agreement and the entire loan must be paid. It does not matter if the loan is repaid early or refinanced because the lender will recoup the entire amount of interest and principle as stated in the contract.

Second, the lender charges percentage penalties based on the balance owed. As the borrower pays down the loan, the penalty or percentage is also decreased.

Third, is known as the “Rule of 78s,” where the interest is paid off before the principle. This means that payments will first be applied to the interest on the loan and second, applied to the principle. In this case, it does not matter if the borrower pays off the loan early or refinances because the lender still get repaid the full interest on the loan.

Congress banned this method in 1992 for loans beyond 61 months. However, it is still allowed for shorter loans in 43 states.

How to Identify Prepayment Penalties

In accordance with the Truth and Lending Act, lenders are required to disclose any penalties within the loan documents; however, some lenders try to conceal penalties within a contract.

Borrowers are encouraged to ask the lender if there is a prepayment penalty included in their contract. Furthermore, it is recommended that they carefully read the contract in its entirety prior to signing.

Can Prepayment Penalties Be Avoided

The easiest way to avoid prepayment penalties is to avoid lenders who add this clause.

If you currently have a loan with the prepayment penalty clause, calculate the amount of the penalty and determine if it would we cheaper to refinance your loan with the penalty included.

Shopping around for a lender before you take out an auto loan is the only way to avoid the penalty. If you do your homework you will not run into surprises should you decide to pay off your loan early.

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