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What Are the Penalties for Paying Off a Car Loan Early?

What Are the Penalties for Paying Off a Car Loan Early?
Austin Kilham

Austin Kilham

Updated September 24, 2021
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Editor’s note: At Lantern, we strive to help you make financial decisions with confidence. To do this, we occasionally feature content that includes information about our partners and their products or services. We do not provide, endorse, or guarantee any third-party product, service, information or recommendations—and our opinions are our own.
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.The reasoning behind it? When you pay off your car loan early (before your loan term is up), your lender doesn’t earn as much money on interest as it would if you paid it off according to schedule. So in some cases it may use a prepayment penalty to disincentivize you from paying the money back early and to help it make up for lost revenue.Not all loans come with a prepayment penalty. When one does, that will be made explicit in the contract. Here’s a closer look at prepayment penalties and the potential benefits and disadvantages of paying off your 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 full interest payments no matter how early a loan is repaid. While this and the Rule of 78s are technically not penalties, they don’t give you the option of saving money by paying off your loan 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. 

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:

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. You may also 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 can also 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 refinancing your loan. When you refinance you take out a new loan, which may offer better terms and rates, to pay off your old one. You may also be able to refinance if you have bad credit, but doing so may be more difficult.

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. To learn more about auto loan options and refinancing, visit Lantern by SoFi. 
Photo credit: iStock/CatLane
The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.SOLC0821141

About the Author

Austin Kilham

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.
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