What Is Precomputed Interest on a Car Loan?

What Is a Precomputed Interest Car Loan?

A precomputed interest car loan is a loan in which the total interest you'll pay is calculated, fixed and divided into monthly payments at the start of your loan term. Your interest payments are largest at the beginning of the loan term and get smaller as you get closer to the end of your term.

Paying extra on a precomputed interest car loan won't reduce your monthly interest payment the way it would with a simple interest loan.

Precomputed Interest vs. Simple Interest

Most car loans are calculated using simple interest. With a simple interest loan, the amount of interest you owe each month is based on your outstanding principal balance. The percentage of your payment that goes toward interest will be larger earlier in your loan term when your principal balance is higher. As you chip away at your principal by making monthly payments, your interest charges will shrink too. This is known as amortization.

Both precomputed interest and simple interest auto loans have higher interest payments at the beginning of the loan term. With a simple interest loan, however, interest payments are based on your principal balance, so making extra payments toward your principal will reduce the total amount of interest you pay.

With a precomputed interest loan, each month's interest payment is fixed at the outset of the loan term and isn't affected by your principal balance. As a result, making extra payments on a precomputed interest loan won't affect the amount of interest you pay.

Learn more: Should You Make Extra Principal Payments on a Car Loan?

How Is Precomputed Interest Calculated on a Car Loan?

Precomputed interest is calculated using what's known as the Rule of 78, sometimes called the "sum of the digits" method. The Rule of 78 adds up the digits of the loan term and uses the result to calculate each month's interest payments.

For a 12-month loan term, you would add as follows:

• 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78

To determine each month's interest payment, you divide the number of remaining months by 78. The first month's interest payment would be 12/78 of the total interest due, the second month's payment would be 11/78 and so on.

Of course, most auto loans are longer than 12 months. For a 48-month loan, you'd have to add up a long chain of digits starting with 1 and ending with 48. A simpler way to calculate this is using the formula:

A 48-month loan would be 48/2 x (48 + 1) = 1,176.

So the interest due on the first loan payment would be 48/1,176; on the second payment, it would be 47/1,176, and so on.

Learn more: How Does Your Credit Score Affect Your Interest Rate?

Pros and Cons of Precomputed Interest Car Loans

When evaluating an offer for a precomputed interest auto loan, consider the pros and cons.

Learn more: Does Paying Off a Car Loan Help or Hurt My Credit?

How to Refinance a Car Loan With Precomputed Interest

A simple interest auto loan is generally a better option than a precomputed interest auto loan, simply because it gives you more financial flexibility. Suppose you get a raise, bonus or tax refund and want to put more money toward your car payment. You can make extra principal payments to whittle down your loan balance and reduce the total interest you'll pay. You can't do that with a precomputed interest auto loan.

That said, there are other factors to consider when deciding whether to refinance a precomputed interest auto loan into a simple interest loan. For instance, if your credit score has improved or interest rates have dropped since you got your loan, you could qualify for a lower interest rate, saving you money. You might also want to refinance into a longer-term car loan to lower your monthly payments. (Just keep in mind that you'll pay more total interest over a longer loan term.)

Whatever your reason for refinancing your car loan, here's how to do it.

1. Check your credit report and credit score. You can check your FICO^® Score^☉ and Experian credit report for free. Good credit (a FICO^® Score of 670 or more) can help you qualify for the best auto loan terms. If your score hasn't improved since you got your auto loan, you'll want to work on improving it before you try to refinance.
2. Shop around. Getting offers from multiple lenders, including banks, credit unions and online-only lenders, can help you find the right auto loan. Aim to submit all your auto loan applications within a 45-day window to minimize any negative impact on your credit score.
3. Compare loan terms. Evaluate each loan offer's interest rate, repayment terms and monthly payment, as well as any fees and penalties. Experian's car payment calculator can help you compare offers.
4. Choose a loan and apply. Submit a final application with the lender of your choice.
5. Accept the loan terms. Review the loan terms to make sure they're acceptable. Once you sign the loan contract, your new lender will pay off your outstanding loan balance. Check your contract to see when payments on your new loan are due.

Learn more: When Does It Make Sense to Refinance a Car Loan?

The Bottom Line

Precomputed interest car loans offer less flexibility than simple interest loans. Because monthly interest payments are set at the beginning of the loan, paying extra toward a precomputed interest loan's principal won't reduce your interest payments.

Are you considering refinancing to get out of a precomputed interest auto loan? If you're working on improving your credit first, consider signing up for free credit monitoring from Experian. You'll be able to track your progress and get customized alerts to keep you on top of your credit.