The past few months this column has examined some of the issues that can affect your financing costs. I hope you have a scorecard handy, because there are a couple more items lingering out there.
In the past three issues of Land Line, I have picked on the bigger subjects that tend to have the greatest impact on your finance deal. Now it's time to take a look at a couple of items which are commonly overlooked, but which can increase your financing costs.
The first is prepayment penalties, which are commonly confused with the "rule of 78s" interest calculation method. The rule of 78s is merely a method used to calculate interest allocation for each monthly installment. Since most often a rule of 78s loan will yield a higher payoff than a "simple interest" loan, most assume it's a penalty.
Although the rule of 78s method is not technically a prepayment penalty, I think most would agree that you have been penalized if your payoff is higher than a simple interest payoff. Actually, if someone takes money out of my pocket, "penalized" is not the first word that comes to mind.
A prepayment penalty is a completely separate issue. Did you know that you could actually have a prepayment penalty on a simple interest loan? Too often individuals are lulled into a false sense of security, because they have a simple interest loan.
Penalty sounds a little too harsh, so some lenders will use the word "premium." I guess it sounds less threatening. Of course, a lot of finance company attorneys would probably say that some state statutes require the use of the word "premium." Although that's an easy argument to buy, let's not forget who helps legislators draft these laws.
Most often a prepayment penalty is a percentage of the unpaid principal balance. For the sake of this article, I am calling it a penalty, and not a premium. I want to apologize in advance to the attorneys out there, but I call them like I see them.
Prepayment penalties can come in all shapes and sizes. For instance, the penalty may be a flat percentage regardless of when the prepayment occurs during the loan term. It may decrease as the term decreases such as 3 percent for the first year, 2 percent for the second year and so on. Prepayment penalties can also be a flat dollar amount.
The impact of a prepayment penalty can be frightening. Not only does it reduce your equity substantially; it also increases your effective annual percentage rate (APR). Just because you started off with 9.00 percent APR, doesn't mean that's what you end up with when you payoff early.
For example: Let's say you have a "simple interest" loan in the amount of $100,000.00 at 9.00 percent APR for 60 months and your loan has a flat 3 percent prepayment penalty. Assuming you made all the payments on time, your principal balance after the 36th payment would be $45,438.10, but your actual payoff at that time would be $46,801.24.
Because you chose to payoff early, the lender has charged you a $1,363.14 prepayment penalty. Magically, your 9.00 percent APR loan transforms itself into a 9.37 percent APR loan. Actually, it's not magic, just increased revenue and profit for the lender. Imagine what that nearly $1,400 would do for your bottom line.
Enough said there. What about documentation fees? Did your last loan have one? It's quite common for lenders to charge between $100 and $500 as a documentation fee. Sometimes this fee is paid up front, but more commonly it is included on the loan document and labeled as either a "document fee" or "other charge." Regardless of what it's called, your loan amount increases.
The practice of including the documentation fee in the loan amount is very effective, because most individuals are relieved that they aren't required to pay it up front. This becomes an easy sell for the lender, but did you know that some lenders will waive the documentation fee and if they won't, the amount can usually be negotiated?
Lenders do have certain up-front costs associated with putting a loan on their books. The lender doesn't begin to make money until you start to make payments, so the existence of a documentation fee can be justified. This becomes an easy argument for the lender to make.
The flaw with this argument however, is the fact that most lenders will finance the documentation fee. Since that fee is financed, the lender only gets a small portion of that fee each month as you make your monthly payments. So much for the argument of covering their up-front costs.
The documentation fee is another one of those items that can be overshadowed by a variety of things. Trucks are very expensive, and in the grand scheme of things, a few hundred dollars can easily be overlooked. Its important to remember that a documentation fee is not reflected in the APR, so if your loan includes one, your effective APR is actually higher, plus you pay interest charges on that fee.
Remember our earlier example? Let's use the same assumptions except in this case you make all 60 payments. Your $100,000 loan amount includes a $500 documentation fee. The lender in reality has only extended you $99,500 in credit, because the additional $500 is a fee they charged you. Your monthly payments though, are based on the $100,000 loan amount. So the effect of that documentation fee increases the rate from 9.00 percent APR to 9.21 percent APR and the $500 documentation fee ends up being $622.80.
You have to read your loan documents thoroughly before signing them; I can't stress that enough. Be sure to not only verify the figures, but spend some time reviewing all the written terms and conditions contained in your loan document. All terms, conditions, fees and figures need to be fully understood.