Prepayment penalties are legal in 36 states, but are not part of every car loan. You will need to read all of the fine print to make sure your loan is not subject to these penalties. The lender is required to make you aware of them, but reading the contract yourself is always advisable. You may be more apt to see these penalties attached to your loan if you have bad credit, subject to a high interest rate, or your loan is for longer than 48 months.
Some car loan prepayment penalties are obvious. They clearly state that the borrower must pay a set percentage of the balance of the loan if the loan is paid in full in less than the set number of months. This type of penalty is illegal on loans that are for more than 61 months.
The Rule of 78’s and Pre-Computed Loan
Other penalties can be more subtle. One penalty is the ”Rule of 78’s”. All of your payments are applied to the full amount of the interest before any amount is applied to the principal. This type of loan repayment ensures that lender receives all of the interest possible. Another option lenders us is called a pre-computed loan. In this situation all of the principle and the interest are included in the loan. A borrower signs the paperwork, agreeing to pay the principle and interest in full no matter what.
The best way to avoid a prepayment penalty on your car loan is to shop around. Try at least three different lenders. Comparing their rates and terms should help you pay the least amount of interest, while avoiding any penalties. Go here for more information on paying off your car loan early.