I would like to prepay on my auto loan. My payments are $261 each month
 with a very high interest rate of 13.9%. I have paid all my other
 debts off and want to start getting the car paid early. I called the
 finance company and they told me all prepayments go to interest first. How
 does this work? Why prepay if I am just giving to interest? This extra
 payment would be above the normal payment. Example: Pay the payment of
 $261 and then write a separate check for $500 each month directed to go
 to principal only. Could you explain this to me?
Carol

Carol has been caught in the auto loan prepayment penalty trap. Back
 when auto loans ran two or three years this wasn’t a problem. But, with
 the average auto loan approaching six years, more lenders have included
 prepayment penalties. Especially for buyers with credit problems and
 high interest loans.

Let’s learn a little about prepayment penalties. Then we’ll see what
 choices Carol has and what the rest of us can do to avoid the trap that
 Carol is in.

Unfortunately for consumers, there’s more than one way to extract a
 prepayment penalty from a borrower who wants to pay off an auto loan
 early.

The simplest method is to charge a percentage of the remaining loan
 balance as a penalty. As the principal owed goes down, so does the
 penalty. Prepayment penalties are allowed in 36 states and the District of
 Columbia. The bad news for the lender is that it’s easy for a consumer to
 understand what’s going on and 14 states don’t allow prepayment
 penalties.

So some lenders dusted off an old method of computing interest commonly
 known as the rule of 78s. It front loads the interest charges - i.e.
 the first payments go toward repaying all of the interest that will be
 owed over the life of the loan. Only after that will payments reduce the
 principal. Paying off the loan early won’t save you any money. In 1992
 Congress outlawed this method for loans longer than 61 months. But 43
 states allow it for shorter loans.

Yet another way to penalize prepayments is found in something called a
 ’pre-computed’ loan. In that loan you agree to repay the total amount
 of interest plus the principal no matter how quickly you repay the loan.
 Again, it’s not technically a penalty for prepaying, it’s just a
 different type of loan. But the results are the same.

So what can Carol do? The first thing is to pull out her loan agreement
 and read the section on prepayments. Also check the section that
 explains how interest is calculated. She needs to know what provisions she’s
 facing.

It sounds as if she has a ‘pre-computed’ or ‘rule of 78s’ loan. If
 that’s the case there’s not much she can do with the loan. The best choice
 is to simply make her payments on time and save the extra money for the
 purchase of her next car.

If there’s a prepayment penalty she can use an online calculator to
 figure out how much interest she’d save by paying the loan early and
 compare that to the amount of the penalty. She’ll find a good one on the
 Bankrate.com site at
 The sad fact is that once you sign an auto loan agreement with one of
 these provisions there’s not much you can do. Occasionally a lender will
 waive the prepayment clause. But not often. The only real option is to
 take the money that would have gone for prepayments and save it where
 it’ll earn some interest.

The best way to fix this problem is to avoid it. Unless you have bad
 credit you should be able to find a simple interest loan with no
 prepayment penalty. A simple interest loan only charges interest on the money
 that you owe each month. Shop around until you find one. Do your loan
 shopping before you find a car. Remember that the loan the dealer offers
 may not be the best one you qualify for.

Read the fine print before you sign any loan agreement. No matter how
 uncomfortable it is sitting in those tiny dealer cubicles with the
 salesperson looking on. It’s important. That’s where you’ll find things like
 the prepayment penalty. Even a knowledgeable person will require a
 half hour to plough through the paperwork. If you’re uncomfortable ask the
 salesperson to leave. They can return after you’ve finished.

Don’t be afraid to ask questions. As we’ve seen there’s more than one
 way to penalize a borrower who wants to repay an expensive loan early.
 Just because you scanned the contract and didn’t see the word ‘penalty’
 doesn’t mean that there’s not one. Ask what happens if you prepay the
 loan. And, be sure you understand the answer.

As a borrower the best answer you’ll hear is that it is a ’simple
 interest’ loan. That means you only pay interest on the amount of principal
 that you still owe each month. If you prepay any of the loan, the
 principal amount is reduced and interest owed is calculated on the lower
 principal the following month.

Finally, if the language seems over your head, take a copy home and ask
 someone who’s familiar with legalese to study it before you sign it.
 Better to risk losing the deal on the car (unlikely) than to sign a loan
 agreement that keeps you trapped with high payments for six or seven
 years.
____________________

Gary Foreman is a former financial planner who currently edits The
 Dollar Stretcher.com website and newsletters. If you wish you had more time
 or money visit The Dollar Stretcher.com site. You’ll find thousands of
 articles to help you stretch your day and your dollar!
 

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