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How to prepay your auto loan: 3 steps

If your car debt doesn't have prepayment penalties, it's good to pay it down

By Gary Foreman

The New Frugal You
New Frugal You columnist Gary Foreman
Gary Foreman is a former financial planner who currently edits The Dollar Stretcher website and newsletters. He writes "New Frugal You," a weekly Q&A column about frugal living, for CreditCards.com

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Question for the CreditCards.com expert

Dear New Frugal You,
Could you outline the process of paying off a car loan ahead of time? Our loan is with a big bank, not local. The payments are taken directly from our checking account, so we are not sending in anything directly each month. My fear is that if I send extra to the bank, it will not get credited. And if it is, how are we notified? Help! -- Lizzy

Answer for the CreditCards.com expert

Dear Lizzy,
It is good that you want to pay off your car loan early. Life without a car payment can make living within your income much easier.

The answer to your question will depend on your specific auto loan. Let's put a step-by-step plan together for you.

Step 1. Find out if you can prepay your auto loan. Some lenders are notorious for either not allowing prepayment of principal or penalizing you for prepaying. They typically prey on borrowers with a low credit score. Often you'll find these loans offered at the "buy here, pay here" car lots. They do that because they are earning a high rate of interest on the loan -- sometimes 20 percent or more!

Chances are that with a big bank loan you won't have a problem. The only way to know for sure is to read your loan agreement or to contact the lender. If there's any doubt, ask them to point out where in your agreement it says that you can prepay.

Step 2. Get your prepayment properly credited. Unless instructed otherwise, lenders will assume that any money they receive (via online payment or check) should be applied to your next payment. So expect them to want your prepayments to be marked "for reduction of principal" or something similar. Ask for instructions.

It's best if you can have those instructions in writing. Having a verbal promise isn't worth much if the lender doesn't credit your payment the way you want. They may be able to point you to a section of your loan agreement or choose to send you written instructions by mail or e-mail.

Step 3. Verify that your prepayment was properly credited. You'll need to compare your account balance before and after the prepayment. You may be able to check the balance due online. If not, a call to the lender can provide the answer. If your principal prepayment was properly credited, the principal due should drop by the exact amount of the prepayment.

A couple of additional notes for you: Once the car is paid off, you have a wonderful opportunity. Keep making car payments to yourself. It's a great way to save for your next car. If you want to make sure that the money doesn't disappear, set up a separate savings account to deposit your monthly "payment" in. Instead of paying interest, you'll be earning interest!

Finally, a warning. The time to find out whether you can prepay principal on your auto (or any other) loan is before you sign the loan agreement. Afterward may be too late. Walk away from loans that prevent or penalize prepayments.

See related: Getting a car loan after bankruptcy, Transfer a small car loan to a low-rate credit card? Yes, but carefully

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Published: February 3, 2011


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