The Right Way To Prepay an Auto Loan

by Gary Foreman

When prepaying an auto loan, how a prepayment is applied does make a difference. Take these steps to make sure your prepayments are saving you money.

Dear Dollar Stretcher,
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?
Terry

The Simple Answer Is Yes

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. 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.

Sign Up for Savings

Subscribe to get money-saving content by email that can help you stretch your dollars further.

Twice each week, you'll receive articles and tips that can help you free up and keep more of your hard-earned money, even on the tightest of budgets.

We respect your privacy. Unsubscribe at any time.

How a Car Loan Works

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.

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 is 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 the principal would increase slightly with every future payment. So, your prepayment today makes every future payment more effective.

Some Lenders Don’t Want You To Prepay Your Loan

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 really 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.

How Can You Know How Your Auto Loan Is Structured?

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!

About the Author

Gary Foreman is the former owner and editor of The Dollar Stretcher. He's the author of How to Conquer Debt No Matter How Much You Have and has been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.