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Precomputed interest loans aren't common, but it's important to know how they work in the event you come across one. With these loans, interest is calculated upfront instead of as you pay your balance, which means you may not save yourself any interest by paying off the loan early.
Understanding how precomputed interest works can help you determine whether such a loan is right for you.
What Is Precomputed Interest?
Most loans use simple interest to determine the cost of borrowing. A simple interest arrangement puts a portion of each monthly payment you make toward the interest accrued since your last payment, with the remainder paying down your principal balance.
With a precomputed interest loan, however, the lender calculates how much you'd pay in interest over the life of the loan if you were just to pay the minimum amount due every month. It then adds that interest to your principal balance and you make your monthly payments as usual.
Precomputed interest loans aren't as common as simple interest loans, but this type of interest is used on some personal loans and auto loans, particularly with auto lenders that specialize in working with borrowers who have poor credit.
How the Rule of 78 Impacts Your Loan
Technically, lenders aren't supposed to be able to charge interest that hasn't yet accrued, which is why you can save a lot on interest if you pay off a loan with a simple interest rate earlier than was originally agreed.
With precomputed loans, lenders use the Rule of 78 to calculate how much interest is earned on a loan with a 12-month term. The rule gets its name from the sum of adding up all the numbers of months in a year, one through 12.
With this rule, the lender can assign each month a share of the total interest owed, but in the reverse order. For example, if you have a 12-month personal loan with precomputed interest, the lender earns 12/78 of the interest during the first month, 11/78 of the interest during the second month and so on.
The same principle applies to longer-term loans as well, so if you have a 24-month loan, you'd add all the digits up from one to 24 to get 300. When interest is applied, 24/300 of the total interest will apply the first month and so on.
As a result, if you pay off the loan very quickly, you may still get some interest savings because the lender didn't earn all of the interest it charged upfront. But those savings disappear fast because most of the interest is considered to be earned early on.
The Rule of 78 is controversial, and the U.S. government doesn't allow it on loans with a repayment term longer than 61 months. What's more, many states have banned the rule entirely.
Pros and Cons of Precomputed Interest Loans
As long as you pay your loan on time and as scheduled with the minimum monthly payment, a precomputed interest loan isn't that different from a traditional simple interest loan. But if you pay off the loan early, the Rule of 78 means you'll end up paying more on a precomputed interest loan.
For example, let's say you borrow $5,000 with a 12-month repayment period, no origination fee and a 20% interest rate. The total interest due over that time is $558, which is added to the principal balance of the loan to make $5,558. Your monthly payment would be about $463.
If the loan were a simple interest loan and you paid it off in two months, you'd save roughly $484 in interest. But if it were a precomputed interest loan, you'd only save $393.
Here's how that's calculated: Because you paid off the loan in two months, the lender uses the Rule of 78, adding up the digits for the first two months—12 and 11, which equals 23—then dividing that number by 78 to calculate how much interest it's earned. The answer is 29.5% of the precomputed interest of $558, which means you'll receive a refund of about $393.
Over time, that refund drops significantly because the amount of interest the lender has earned is frontloaded.
How to Avoid Precomputed Interest Loans
If you don't have any plans to pay off your loan early, a precomputed interest loan may not present any issues. But if you'd rather avoid the potential problems that can arise when prepaying the loan, there are a few options to consider:
- Pick a different lender. If you have poor credit, your options may be limited. Depending on the type of loan you need, however, there may be plenty of alternative lenders from which you can choose. Be sure to compare other important features, such as the loan's interest rate and fees. While a precomputed interest loan isn't ideal, you typically won't be better off choosing another lender if the interest rate on their loan is much higher or the repayment term is shorter than you'd like.
- Find a cosigner. A creditworthy cosigner may be able to help you qualify for a better loan that doesn't require precomputed interest. Just be sure your cosigner understands what it means to cosign a loan and how it might impact their credit.
- Improve your credit. If you absolutely need the loan funds now, you may not have time to build your credit before you apply. But if it's not urgent, taking some steps to improve your credit can help you qualify for more quality borrowing options. Start by reviewing your credit report, which you can get for free through AnnualCreditReport.com. You can also check your FICO® Score☉ and review your Experian credit report for free through Experian. Reviewing this information can give you an idea of what you can address to potentially improve your creditworthiness. For example, it may mean getting caught up on past-due payments, paying down credit card debt or disputing fraud.
What to Do if You Already Have a Precomputed Interest Loan
If you've already taken out a precomputed interest loan—knowingly or unknowingly—it may be best to stick with it. Refinancing is an option, but it could ultimately cost you more.
Let's take another look at the previous example to run the numbers and see why. If you were to pay just the minimum payment on a precomputed interest loan during the first two months, your loan balance would be $4,632. With the $393 refund you'd get when you refinance, your total interest paid on the first loan would be $165.
Assuming your new loan has a 20% interest rate and a 12-month repayment period—you may find it difficult to find a new loan with a 10-month term—your new monthly payment would be about $429, and the total interest would be $516. Add that to $165, and the total interest between the two loans would be $681 compared to $558 if you had simply stuck with the original precomputed loan.
In this situation, it's best to repay the loan as agreed. But it may be worth it to find another loan depending on your repayment plan and the interest rate you can get with the new loan.
Read the Fine Print Before You Accept a Loan
Before you accept a loan, make sure you understand how interest is calculated. Also, plan to shop around and compare rates from multiple lenders to get a variety of options. Tools like Experian CreditMatch™ can help you shop around by making it possible to compare offers side by side based on your credit profile.