The Basics Of Prepayment Penalties
Auto loan prepayment penalties are financial penalties designed to prevent borrowers from repaying their debt early, thereby carving out a more profitable path for lenders. When a borrower tries to pay off the debt sooner than the agreed term, the lender misses out on interest that would have otherwise accrued over the life of the loan. To manage these potential losses, lenders may charge the borrower for early repayment with prepayment penalties.
These penalties vary by lender and state laws. In the US, roughly 70% of states allow these charges. It is to be noted that penalties are implemented on auto loans with terms less than 48 months. However, these are banned across the US for all auto loans with terms exceeding 60 months.
Keep reading to learn more about these penalties and how you can avoid them.
Why Lenders Charge These Fees
If borrowers obtain a car loan, they must pay the monthly installment over the life of the loan. For example, the lender would be deprived of 22 months of interest if a borrower accepted an auto loan for a term of 30 months, but finished its payment after just eight months. As the interest accrues every month over the life of the loan, it increases the profit margin of the lender. When the borrower pays off the loan early, the debt is nullified and all accruals cease. This can turn into a loss for the lender.
To balance the risk of this loss and ensure an adequate return on investment, lenders impose prepayment penalties. This leaves the borrower with two choices - repay the loan as per the term, thus ensuring the lender receives an adequate profit for their risk, or pay the charges, which in turn also ensures the lenders generate some profit.
How It Is Calculated
Most penalties are mentioned in the loan contract. A penalty fee is usually a percentage of the remaining balance of your loan. Listed below are the most common ways lenders use to calculate these penalties:
- The straightforward way is to charge a flat percentage on the remaining loan balance as a penalty. For instance, if you have a remaining balance of $13,000, and the penalty is 4%, you’ll pay $520 as penalty.
- Another way to charge a penalty is based on the interest cost. These charges vary depending on the lenders. While some might charge you less, others might charge as much as six month’s worth of interest as a penalty.
- A pre-computed charge is yet another way of levying this penalty. In this scenario, you’ll be bound to repay the total interest and principal irrespective of how quickly you pay off the loan.
How You Can Avoid Penalties
There are certain ways to avoid these unnecessary penalties. We have compiled the best workarounds to help save your hard-earned money below.
Paying A Portion
Depending on the terms, you may be able to prepay a portion of your loan annually without penalties. For instance, some lenders allow you to prepay up to 20% of your balance annually without a prepayment fee.
Let’s say, you have a loan of $20,000 for 48 months at 7% APR. This means, you’ll pay a monthly amount of $479. By the end of 2020, you’ll have paid $3,200 and your outstanding balance will be around $17,500. At this point you can opt to pay off at least 20% of the remaining balance, or $3,500, without any additional fee.
Waiting For The Right Moment
Most loan prepayment penalties tend to change over time. Depending on the scenario, they might decrease, increase, or be waived-off in full. It is important to keep track of the changes and wait for the right time to make additional payments to clear off the loan.
You can keep in touch with the lender and review the loan terms to get a better idea. Understand the terms mentioned in your loan contract and wait for the right time to pay off the debt without the need to pay additional charges.
A few lenders agree to let go of the penalty for prepayment if you agree to sell the vehicle. Let’s say you owe $15,000 on the loan and wish to close the loan account by making an early payment. If you proceed, you will face extra charges.
However, if you sell the car and repay the remaining $15,000, the lender might not issue the penalty. Still, if you wish to refinance the loan, you’ll end up paying the penalty. Accordingly, check the loan agreement carefully before making any decision which could result in a penalty.
Even if you have the means to pay off the debt before the end of the loan term, it is a good idea to review a loan agreement and consult the lender to verify the prepayment penalties. In many cases, lenders will charge a fine to cover the interest deficit. By following the tips listed above, you can avoid paying these penalties altogether or avoid any unnecessary fees.