Expert Q&A

Prepaying principal, paying ahead not the same


Your auto lender would probably prefer you just pay ahead, since that won’t cost them anything. But if you want to lower your costs, prepay the principal.

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Question for the expert

Dear New Frugal You,
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 toward the next payment but it would still lessen the time of the note the same as if it went directly toward 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

Answer for the expert

Dear Terry,
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.

There are about 1.5 million cars and light trucks are sold each month according to the National Association of Auto Dealers. Most of them will be financed with an auto loan. The language in your loan contract determines how prepayments are applied.

How they’re applied can make a big difference in the cost of your car. What they told you sounds misleading.

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 it for.

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 from the situation if all of it went to reduce the amount borrowed.

If all of the $300 is applied to reduce the principal owed, then you’ll reduce the amount you owe by an extra $300. That shortens the length of time you’ll be paying the loan. So your prepayment today makes every future payment more effective.

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 real 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.

So how can you know what’s really happening? 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.

If you can prepay without penalty, you can see how much you’ll save using a good calculator.

In either case, I hope that you enjoy your new ride!

See related: Understanding auto loan prepayment penalties 3 steps to prepaying your auto loan

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