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Paying off your car loan early may not be right for you if your auto loan contract includes a prepayment penalty clause. A prepayment penalty is a fee that lenders may charge when you pay some or all of a car loan early. Not all lenders penalize you for prepaying, but some will. Below we highlight how prepayment penalties work and explain the potential benefits and disadvantages of paying off your car loan early.Spotting Prepayment Penalties
Lenders may work prepayment penalties into your contract in a couple of different ways. These include: Percentage Penalties
You may be charged a certain percentage of your remaining balance if you pay your loan off early. The longer you’ve had the loan, the lower the penalty will be. This type of penalty is not legal in every state or for every loan, and it must be disclosed in the loan documents. Rule of 78s
Lenders may also try to disguise prepayment penalties. For example, in some states, lenders may use the Rule of 78s, in which your payments go toward paying off the full interest amount calculated on the loan before they are applied to the principal. This ensures interest payments are made in full even if you pay the loan off ahead of schedule. Precomputed Loans
Precomputed loans calculate the full price of a vehicle and interest rates in the loan, and the borrower agrees to pay off both. This is another way lenders ensure they receive as much interest payments as possible if you decide to pay the loan off early. When comparing different types of car loans, precomputed interest auto loans may not be as consumer-friendly as simple interest car loans.While precomputed interest car loans and the Rule of 78s are technically not penalties, borrowers typically don’t see great savings when paying these loans off early. Watch out for these contingencies in loan contracts as you shop for an auto loan, and don’t be afraid to negotiate to have them removed or look for a lender that doesn’t impose them. Potential Benefits of Paying Off a Car Loan Early
If you find that you have room in your budget to pay off your car loan faster, there can be a number of possible benefits. Saving on Interest
You may be able to pay off your loan early in one lump sum or by adding money to your monthly payments. Auto loan payments are amortized over the term of your loan. A commonly used loan term, amortization refers to your schedule of loan payments and what exactly each part of each payment pays for. A portion of your payment is used to pay off your loan interest and fees, and the rest goes to paying off your principal. If you add money to your monthly payment, that money will go directly to paying off your principal. If your interest payments are calculated using a simple interest formula—meaning they’re calculated based on the balance of your loan—you will reduce your interest payments. If your interest payments are precomputed, they won’t change. Improving Your Debt-to-Income Ratio
Your debt-to-income ratio (DTI) is a measure of how much money you owe compared to how much money you have coming in. Lenders use it to help them determine how much risk they’d be taking on if they offered you a loan. If you’re seeking new credit, paying off your car loan early can lower your DTI, which demonstrates that you likely have enough income to pay back a new loan. Freeing Up Cash
Paying your loan off early can free up that cash to be used for other financial goals, from saving for an emergency fund to socking away cash for retirement. In the second quarter of 2021, the average monthly auto payment for a car was $465, which is a sizable chunk of change, especially added up over the course of a year.Avoiding Going Upside Down
Cars depreciate over time, and often faster than your loan term. That can mean that at some point you may end up owing more on your auto loan than the car is actually worth. That’s especially likely if your term is long or if you have a particularly high interest rate. Prepayment can help you avoid an upside down loan. Potential Disadvantages to Paying Off a Car Loan Early
While there are potential advantages to paying off your loan, there are also some disadvantages—in addition to prepayment penalties—that may make you think twice.Your Credit Score May Take a Hit
It’s strange to consider, but paying off your debt early may actually hurt your credit score. Your credit mix and payment history make up a portion of your score. When you pay off your loan early, your track record of on-time payments gets cut short. Also, a mix of different kinds of credit is a plus, and paying off your auto loan will remove one type of loan from that mix.On the bright side, the dip in your credit score is usually temporary as long as you continue to manage your other debts responsibly. Lenders typically report loan account information to the credit bureaus every month.Opportunity Costs
If you’re using extra cash to pay off your car loan early, that means you’re not using it for other potentially more beneficial purposes. For example, if you have high interest credit card debt, you may save more money tackling that first than you would paying off your car early. Pros and Cons of Prepayment at a Glance
Here’s a quick summary of some of the pros and cons of paying off your car loan early: | Pros | Cons |
|---|
| Saving Money on Interest: When you pay down your principal early, you may eliminate some interest you would have otherwise owed. | Possible Prepayment Penalties: Your lender may charge you fees for paying off your loan early to compensate for lost interest payments. |
| Freeing up cash: Paying off your loan early can free up cash you can use toward other goals. | Could Lower Credit Score: Your credit score may dip temporarily. |
| Improve Debt-to-Income Ratio: Paying off your loan can improve your DTI, potentially making it easier to qualify for other credit. | Opportunity Cost: Your extra funds may be better used elsewhere, such as paying down high-interest credit card debt. |
When to Consider Paying off an Auto Loan Early
If you have the cash available, you may want to consider paying off your auto loan early if: - You don’t have any high interest debts to tackle first.
- You already have an emergency fund saved.
- You know you’ll be seeking additional credit in the near future, such as applying for a mortgage, so you want to improve your DTI.
- The money you save on interest is more than the penalty (if there is one).
Options for Paying Off a Car Loan Early
You have a handful of options of paying off your auto loan. If you’ve recently had a financial windfall, such as a bonus at work or an inheritance, you may pay your loan off in full in one lump sum. Here are other prepayment options you may consider:- With a bonus or inheritance, you may be able to make smaller lump sum payments to pay off chunks of your loan at a time. You won’t eliminate interest payments in this case, but you will potentially make them smaller.
- You may increase the amount you pay each month to pay down principal, again potentially lowering the amount of interest you pay.
- Finally, if you’re seeking to lower your interest rate or make your monthly payments more manageable, you may consider auto refinancing your car loan. When you refinance you take out a new loan, which may offer better terms and rates, to pay off your old one.
The Takeaway
Prepayment penalties are relatively rare. But before you sign up for any loan, be sure to comb through the loan documents carefully to see if one is included. And as for an existing loan, even if your lender does charge a fee for prepayment, it may make sense to prepay anyway if you save more in interest in the long run.Find and compare auto loan refinance options with Lantern by SoFi.
Photo credit: iStock/CatLane
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About the Author
Austin Kilham
Austin Kilham is a writer and journalist based in Los Angeles. He focuses on personal finance, retirement, business, and health care with an eye toward helping others understand complex topics.
