Making sure your prepayments save you money

Prepaying an Auto Loan

by Gary Foreman

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Auto Loan Prepayment Penalties

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I just purchased a new vehicle and obtained a loan for 60 months. I contacted the loan department and was told there was no prepayment penalty. I asked if I added an extra $300 if it would be taken off the principal. I was advised that the extra $300 would be applied towards the next payment, but it would still lessen the time of the note the same as if it went directly towards the principal. The loan company is a large institution. My question is this. Does it make a difference by prepaying to the principal as compared to prepaying the next payment?

The simple answer is, yes, it does make a difference where a prepayment is applied. And the answer is important to anyone with an auto loan.

There are about 1.5 million cars and light trucks sold each month according to the National Association of Auto Dealers (NADA). Most of them will be financed with an auto loan. The language in your loan contract determines how prepayments are applied.

And how they're applied can make a big difference in the cost of your car. What they told you sounds misleading.

Let's begin by understanding how your car loan works. You borrow an amount of money and pay interest for the privilege. The amount of interest you pay depends on how much money you borrow, the rate of interest, and how long you borrow it for.

When you make your monthly payment, part of it goes to pay the interest you owe since the last payment and the rest of the payment goes to reducing the amount that you've borrowed. If you send in extra money, you'd expect that it would all be applied to reducing the amount borrowed. But, depending on your contract, that's not always true.

They told you your money would be applied to your next payment. If that's the case, some will be going to the interest that will be due and only a portion goes to the amount borrowed. That's much different than if all of it went to reduce the amount borrowed.

If your interest rate were 5% and all of the $300 is applied to reduce the principal owed, then an extra $1.25 ($300 X .05 / 12) of your next monthly payment would go to principal reduction. And the amount applied to principal would increase slightly with every future payment. So your prepayment today makes every future payment more effective.

But some lenders don't want you to be able to prepay your loan, especially if you have a high interest rate. They'll include a "prepayment penalty" in your loan agreement or even set up your payment schedule using something called the "rule of 78s."

Rule of 78s loans are a real creative way to get your money. Mostly you'll see them on "buy here, pay here" used car lots. In a rule of 78s loan, you pay all of the interest owed for the entire loan period first and only after that's done do you begin to pay down the principal owed. So paying early does you no good.

In many places, rule of 78s loans and prepayment penalties have been outlawed.

So how can you know what's really happening? You could go to your loan agreement and try to translate the legalese. Or give it to someone you trust to translate for you.

But, there's an easier way. Call and ask how much it would cost to pay off the entire loan today. And then ask how much it would cost to pay off the entire loan after you sent them $300 marked for principal reduction. The answer should be $300 less. If it's not, you know that they're not applying all of it to reducing principal.

You should check the total amount owed before and after any prepayment to make sure that it's been applied properly.

If you have a loan agreement with a prepayment penalty, you're probably stuck with it. You might want to check with your state's consumer affairs office to see if you can undo the loan. It's possible that you fall within a grace period, but you may find that prepayments won't help and you'll just need to pay it off on schedule.

However, if you can prepay without penalty and want to know how much you'll save, here's a good calculator.

In either case, I hope that you enjoy your new ride!

Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, and Gary shares his philosophy of money here. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.

Take the Next Step:

  • If you're considering an auto loan, read the fine print before you sign any loan agreement.
  • If there's a prepayment penalty in your current agreement, use an online calculator to figure out how much interest you'd save by paying the loan early and compare that to the amount of the penalty. You can find a good one on the site.

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