This difference gets more extreme if you pay the loan off earlier or if you borrow a larger amount of money. That means you'd only save yourself $582. With a precomputed loan, your remaining account balance would be $6,378 after 24 months and you would've paid $1,018 in interest to date, due to the Rule of 78 stacking the earned interest at the beginning of the loan term. You would save yourself $605 in interest that you would have paid had you taken the full five years to pay back what you borrowed. If you pay off the $6,355, there is no principal balance left to accrue interest and your loan is considered paid off. At that point, you would have paid in about $995 in interest if you had a simple-interest loan and your remaining balance would be $6,355. Now let's imagine that after two years, you decide you want to pay your loan off. You'd pay $1,600 in interest in either case. If you made the minimum payment every month of the loan term, your final cost comes out about the same no matter which loan type you have. To help you get a sense of how precomputed loans work, let's consider a $10,000 loan with a 6% APR and a five-year loan term. precomputed interest loans: A side-by-side comparison When you try to pay back your loan early, you will get a refund, but it will be less than it would have been for a simple-interest loan because the lender is able to lay claim to more of your interest more quickly. ![]() The model is set up so that most of your interest is considered "earned" early on in the loan term. In your first month, the lender would earn 24/300 of the interest, 23/300 in the next month, and so on. If you have a longer loan term - say 24 months - you would calculate it the same way as above, but you would total up the numbers 1 to 24 to get 300. In the second month, it earns 11/78 of the interest, and so on. So in the first month of a 12-month precomputed loan term, the lender earns 12/78 of the interest. Each month of the loan is assigned a portion of the interest in reverse order. It's called the Rule of 78 because that's the sum of all the digits of the months in a year (1+2+3+4+5+6+7+8+9+10+11+12). It heavily favors the lender and is so controversial that the federal government banned lenders from employing this strategy for loans longer than 61 months, and 17 states have banned it outright. This arcane formula determines when lenders are considered to have "earned" the interest you're paying on your loan. It sounds like it's just a different way of doing things that should cost you about the same amount as a simple-interest loan, but it's not and that's all thanks to the Rule of 78. In theory, the lender must refund you any interest it hasn't "earned" because you didn't hold onto its money as long as expected. If you pay the minimum amount every month, the cost ends up being similar to what you'd pay with a simple interest loan.īut if you want to pay your loan off early it is not so simple. Each payment you make reduces your account balance until you reach zero. This is added to your principal to get your account balance. Instead, they calculate the total interest you would pay for the whole loan term if you made the minimum monthly payment as if were a simple-interest loan. Precomputed loans don't allocate a portion of each payment to the principal and a portion to interest like simple interest loans. ![]() Precomputed loans work a little differently and they can be costly to those who plan to pay off their balance ahead of schedule. When your principal reaches zero, there's no balance left to accrue interest and you're done paying off the loan. As your principal balance shrinks, so does the amount of interest you pay every month because the interest is calculated based on your current principal balance. Most loans today are simple-interest loans, where part of each payment goes toward the principal and part goes toward the interest. But there's another thing you should look into before you sign on that dotted line - how the lender applies payments to your balance. You probably pay attention to the interest rate when you apply for a loan, and if you're smart, you also check for prepayment penalties to make sure you won't get hit with extra fees if you decide to pay your loan off early. Promo: Hint: It's another trick lenders use to line their pockets at your expense.
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