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Auto Loan Guide Step 8: Prepayment Terms and Automobile Loans

       So you're just about to sign the papers on an automobile loan, and like all smart consumers you are reading over the agreement before you sign. While reading, you stumble across a section called Prepayment Terms. You look at it and think, "I don't care about this section," and then proceed to skip over it. But don't. That section is very important.
    I know, you don't plan on prepaying your loan. In fact, the thought of prepaying your automobile loan might sound comical right now. After all, you probably budgeted your finances perfectly so that you could afford your monthly payment and nothing more. And I understand where you are coming from; however, you may change your mind in the future. You might get a raise, inherit some money or if you're really lucky, win the lottery. And with all that extra cash burning a hole in your pocket, you may have a strong moment where you pass on buying that high speed motor boat and decide that you should be responsible and pay off your automobile loan.
    Good move. Paying off your automobile loan early is always smart. In fact, most financial advisers urge you to do it. That's because you save money when you prepay your automobile loan. However, if you don't pay close attention to your loan's prepayment terms, you may not save very much.

Bad Prepayment Terms in Automobile Loans

Prepayment Penalties

    Lenders get tricky when it comes to prepayments. You see they really don't want you to pay off your automobile loans early, because they don't make as much money. So some lenders try to charge you a fee if you prepay your loan, known as prepayment penalties. Those penalties are a complete rip off and you should never sign a loan that has one. You should be able to find a loan that doesn't penalize you for paying off your loan early.
The Rule of 78

       The Rule of 78 is another way that lenders try to make money from you when you prepay your automobile loans. Essentially, the Rule of 78 is a very complicated way of calculating interest. All you really need to know is that automobile loans that use the Rule of 78 cost you more than simple interest automobile loans.
    Luckily, many states have outlawed the use of the Rule of 78 (Boyett 131). However, not all have. So it is important to check your prepayment terms to see if your lender uses the Rule of 78. When lenders use the Rule of 78, they give rebates when you pay off your loan early. The Truth-in-Lending Act requires all lenders to state whether you will be given a rebate if you repay your loan early ("The Rule of 78's"). If your automobile loan's prepayment terms mention anything about rebates, you may want to watch out. Simple interest automobile loans - which are the ones that save you the most money when you repay your loan - do not use rebates. So if your prepayment terms say you will get a rebate if you pay off your loan early, you may want to ask your lender is they use the Rule of 78. If they do, find a different automobile loan. 

The Rest of Our Auto Loan Guide:


Boyett, Joseph H., and Boyett, Jimmie T. The Guru Guide to Money Management. Hoboken: John Wiley & Sons Inc., 2003.

"The Rule of 78's". Division of Banking. 11 Oct 2006.