What are auto loan prepayment penalties?
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UPDATED: Oct 11, 2012
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Auto loan prepayment penalties are essentially financial punishments intended to dissuade borrowers from paying off their debt too early, which effectively robs lenders of interest payments and profit.
When borrowers obtain an auto loan, they must make monthly payments to repay the debt. For example, if a borrower agreed to finance an auto loan with a term of 30 months, but wound up repaying it in 8 months, the lender would feel robbed of 22 months’ interest. As interest accrues each month, it increases the amount of profit a lender will make. Paying off an auto loan early ends the debt owed to lenders and ceases all interest accrual.
But in order to ensure they see an adequate return on their money, lenders impose prepayment penalties. Prepayment penalties give borrowers a choice: either repay their loan over the agreed-upon time, thus awarding the lender with the lender’s expected profit, or satisfy the lender’s prepayment penalty, which also awards lenders with some extra money.
Common Prepayment Penalties
Perhaps the most common prepayment penalty found on contracts requires borrowers to pay a percentage of whatever balance remains—or would have remained—if their debt had not been paid off prematurely. Fortunately, each contract has an expiration date for this penalty that, once passed, makes the penalty no longer applicable. Borrowers who are prepared to prepay their auto loan should check their contracts and make sure this prepayment penalty duration has expired before paying their note off.
Another (more severe) type of prepayment penalty requires borrowers to pay the entirety of their auto loan’s interest and principal regardless of when the borrower repays their debt. If a borrower had been making timely payments and reduced their balance but still desired to repay early, they would be in for a shock. The borrower wouldn’t just owe his or her remaining balance, but instead would also owe whatever interest would be accrued on that balance if he or she were to continue making normal monthly payments. On agreements like this, there is no financial benefit to repaying early.
Nearly all auto loans come with prepayment penalties so borrowers shouldn’t feel bad if they find them in their contract’s fine print.
In the event an auto loan does not come with a prepayment penalty, lenders will likely structure the financing with front-loaded interest. Under front-loaded interest-bearing loans, a borrower’s initial payments go towards paying off the interest and not the principal. This means that when a borrower pays their debt off early, the lender has already received a larger portion of the total interest on the principal amount.
Confused borrowers, or borrowers unfamiliar with contracts, should never feel afraid to ask questions of lender representatives. Further protecting borrowers are the many state and federal laws which prevent lenders from deceiving or withholding information from applicants. Borrowers should never agree to a contract they are uncomfortable with or do not fully understand.