Key takeaways
- Precomputed car loans front-load interest payments much more than simple interest car loans, but you will still pay more interest at the beginning of a loan regardless of the way interest is calculated.
- While you’ll pay the same amount of interest over the full loan term, precomputed car loans distribute interest in a way that makes early repayment less beneficial for borrowers looking to save money.
- 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 out over the life of the loan based on your principal balance each month, 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. However, if you make extra payments on your precomputed interest loan and pay it off early, it’s still possible to get a refund or rebate — but you won’t save as much as you would with a simple interest loan.
How a precomputed interest auto loan works
“Precomputed” means the lender calculates the interest on a loan and divides it evenly across the loan term. This is in contrast with how interest is calculated on a standard simple-interest loan. When you borrow money with a simple interest loan, the lender calculates interest based on the amount of your outstanding balance each month throughout the life of the loan.
The amount you pay in interest will be the same. However, a precomputed interest loan benefits the lender. If you pay your loan off early, your lender will already have collected the majority of interest you owe.
Precomputed interest loans 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 borrowers with bad credit. Because of this, they tend to have high interest rates.
Precomputed interest vs. simple interest
While precomputed interest front-loads what you pay, interest on a simple interest loan is calculated using the outstanding principal balance each month. Because paying more than the minimum payment cuts down on the principal, additional payments or early repayment on a simple interest loan will reduce the total amount of interest you pay.
You will still save some money on interest if you make additional payments or repay a precomputed interest auto loan early. That said, the way interest is distributed means you will receive less of a refund or rebate than you would with a simple interest auto loan.
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 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 will 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, but 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 are interest refunds calculated?
Refunds are calculated by subtracting the interest you have already paid from the remaining interest on your loan. Because the interest is front-loaded — 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.
For example, consider a $26,000 auto loan at a 12% interest rate and a 48-month term. When added together, a 48-month loan term will have a precomputed interest term equal to 1,176. Your refund will be calculated like this:
- Lenders determine the total amount of interest you pay. In this case, it is $6,865 over a 48-month term.
- If you choose to pay your loan off at the 20-month mark, you will divide the total of the 28 months left in the loan — 812 — by the total precomputed interest term of the entire loan — 2,352. The rounded result is 0.35.
- Once you have a decimal, which represents the percent of the loan you have paid, you then multiply this amount by the total interest of the loan to determine your rebate. For this example, you multiply 0.35 by $6,865 to get a final rebate of $2,402.75.
The lender will have earned 65 percent of its interest even before the halfway point, so you will receive a refund for the remaining 35 percent. Note that, in this example, we are rounding at the second decimal — the lender may calculate based on the whole decimal, which could impact the final rebate amount.
How to use the precomputed interest rebate formula
Precomputed interest rebate formula
(R * (R +1)) / (T * (T+1)) = D * I = Rebate Amount
Here’s the key:
- R = remaining loan term
- T = total loan term
- D = percent of loan remaining
- I = total interest paid
And here’s what it would look like using the example loan. To find D, start by dividing the remaining loan term by the total loan term:
- (28 * (28 + 1) / (48 * (48 + 1) = D
- (28 * 29) / (48 * 49) = D
- 812 / 2,352 = 0.35
- D = 0.35
Once you have D, you can multiply it by the total interest paid over the life of the loan to get the rebate amount:
- 0.35 * $6,865 = $2,402.75
Therefore, $2,402.75 is the rebate you will receive if you pay back a precomputed interest loan early.
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, you are more likely to be offered it if you have 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 on 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 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.
You can always consider refinancing your auto loan once you’ve improved your credit score. While you may not have the same savings, switching to a simple interest loan — and then repaying it quickly — may help you save a little money. However, you should run the numbers carefully to determine if it will save enough to be worth the time of switching lenders.
Bottom line
If you’re offered a precomputed auto loan, consider if you want to pay off your loan early or make additional payments. You will pay the same amount in interest on a precomputed interest auto loan as a simple interest auto loan. But if you plan to repay your debt early, a simple interest loan will generally mean saving more money.
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