September 29, 2022

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What Precomputed Interest Is & Why You Should Avoid It

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.

Ultimately, there are few differences between simple interest and precomputed interest auto loans if you make minimum payments. And you’ll still get 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 that 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.

You will receive an interest rate and an annual percentage rate (APR) that includes any additional fees. Overall, precomputed loans are the same as simple interest loans. The way interest is calculated benefits lenders if you repay early, but if you don’t, you likely won’t notice anything special about a precomputed interest auto loan.

The rule of 78

Lenders are not legally allowed to charge you interest that hasn’t accrued. But they can change the way interest is divided over the course of a loan.

The rule of 78 is one of the main tactics — and the basis for precomputed interest auto loans. The name comes from adding up all the numbers in the year and then applying interest in reverse order. You will pay 12/78 of the interest due in the first month. The second month is 11/78, the third month is 10/78 and so on.

By charging interest like this, you will pay more at the start of your loan. This means that you can get a rebate on interest if you pay off your loan early, but it won’t make a significant impact on the overall cost.

Precomputed interest vs. simple interest

While precomputed interest front-loads what you pay, simple interest splits the interest paid evenly. This means that paying more than the minimum payment cuts down on the principal, which in turn means you pay less interest the next month.

If you only ever 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.

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. So, if you don’t qualify for a simple interest auto loan, you may still be approved for a precomputed interest loan.
  • There is no difference in how much interest you pay with a precomputed interest auto loan. By following 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. You will pay more in interest if you repay your loan early, which means less savings for being financially responsible.
  • Since lenders can only use precomputed interest on loans shorter than 60 months, you may have higher monthly payments. This does mean you pay less interest overall, but if you only qualify for a precomputed interest auto loan, it may make your loan more expensive from month to month.

Why you should avoid precomputed interest auto 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 precomputed auto loans front-load the interest you will pay, you’ll miss out on savings. It may only be a small difference, but it’s still your money. The less you have to pay your lender, the better.

Next steps

Precomputed interest auto loans are avoidable, but they also are not the worst thing if you plan to make minimum payments. However, you can compare auto loans to find more lenders — and potentially a better deal.

Learn more