What is a precomputed interest car loan?
Key takeaways
- Precomputed interest car loans are less common than simple interest loans and front-load the interest, which means you pay more at the onset of the loan rather than at the end.
- These loans can benefit the lender more than traditional options, resulting in more being available for bad credit borrowers.
- Although illegal in some states, the rule of 78 can make precomputed interest car loans more expensive for borrowers than simple interest loans.
Precomputed interest is an uncommon way of calculating interest on an auto loan that benefits the lender. Rather than spreading the interest evenly out over the life of the loan, the interest is front-loaded — meaning you pay more interest at the beginning of the loan and less at the end.
If you make minimum payments, there is no difference between simple interest and precomputed interest auto loans. You will get some money back if you pay off your auto loan early, but it will be less than with a simple interest auto loan.
How a precomputed interest auto loan works
“Precomputed” means the lender calculates the interest you will pay over the loan term. It then adds this interest to the principal and splits it into monthly payments, similar to standard auto loans that use simple interest. The way interest is calculated benefits lenders if you repay early.
They aren’t as common as simple interest loans. You are more likely to find them offered by buy-here-pay-here dealers and other lenders that work with bad credit borrowers. Because of this, they tend to have high interest rates.
You will receive an interest rate and an annual percentage rate that includes any additional fees.
Precomputed interest vs. simple interest
While precomputed interest front-loads what you pay, simple interest loans split the interest paid evenly. Paying more than the minimum payment cuts down on the principal, which means you pay less interest the next month.
If you only make the minimum payment, there won’t be a difference between these two ways to calculate interest. But if you plan to try to repay your auto loan quickly, simple interest loans are the better choice.
The rule of 78
Lenders are not legally allowed to charge you interest that hasn’t accrued. But they can change how interest is divided throughout a loan — the rule of 78 changes how you calculate interest, not the total amount you pay.
The rule of 78 is one of the main tactics — and the basis for precomputed interest auto loans. Lenders add up all the months in the year, which total 78, and then apply interest in reverse order. During a one-year loan, you would pay 12/78 of the total interest due in the first month. The second month is 11/78, the third month is 10/78 and so on.
This means you will pay more at the start of your loan. You can get a rebate on interest if you pay off your loan early, though you won’t save as much as you would with a simple interest loan.
Some states have banned using the rule of 78 — and it is nationally illegal for loans lasting 61 months or longer. Check your state’s laws to ensure your lender isn’t offering you an illegal loan.
How is an interest refund calculated for precomputed interest auto loans?
Refunds are calculated by subtracting the interest you have already paid from the remaining interest on your loan. But because the interest is frontloaded — you pay a greater portion at the beginning of the loan — you will have less refunded the longer you take to pay off your loan.
Consider the following example for a $30,000 loan with a 60-month term and a rate of 6 percent, where you will pay about $4,800 in interest. Imagine you pay the loan off two years early. Here’s how the lender calculates how much interest it can keep.
- Multiply 78 by three (the number of years you took to pay the loan) to get 234.
- Divide 234 by 390, the rule of 78 multiplied by five years (the original loan term).
- Multiply the result, 0.6, by 100 to find the percentage.
The lender will have earned 60 percent of its interest at this point. So you will receive a refund for the remaining 40 percent — totaling $1,920.
Benefits and drawbacks of precomputed interest
Precomputed interest is only a drawback if you want to pay off your loan early. Otherwise, it will cost you the same as a simple interest loan.
Pros
- Because precomputed interest benefits the lender, they are more likely to be offered to borrowers with less-than-perfect credit. You may still be approved for a precomputed interest loan if you don’t qualify for a simple interest auto loan.
- There is no difference in how much interest you pay with a precomputed interest auto loan. If you follow the minimum payment schedule, a precomputed interest loan is exactly the same as a simple interest loan.
Cons
- The major drawback with precomputed interest is early payments. If you repay your loan early, you will pay more in interest, which means less savings for being financially responsible.
- Since lenders can only use the rule of 78 on loans with terms of 60 months or less, you may have higher monthly payments. If you only qualify for a precomputed interest auto loan, your loan may be more expensive from month to month.
Why you should avoid precomputed interest car loans
In general, simple interest is the better option for almost every borrower. Even if you don’t have plans to repay your loan early now, your situation could change. And if it does, a simple interest loan will mean you pay less overall.
Because you pay more interest at the start of a precomputed auto loan, you’ll miss out on savings if you repay early. It may only be a small savings, but it’s still your money. The less you have to pay your lender, the better.
The bottom line
Precomputed interest auto loans are avoidable, but they are not the worst if you only plan to make minimum payments. Still, you should compare auto loans to find more lenders — and potentially a better deal.
You may also like
Co-borrower vs. cosigner: What’s the difference?
Statute of limitations on car repossession
