Auto loans typically fall into one of two basic categories — simple interest and pre-computed.
Interest is calculated solely on the remaining principal balance of a simple interest loan. In other words, you’ll only be held responsible for the interest earned over the period of time the loan was outstanding if you pay the loan off early.
However, you agree to pay the full amount of interest the loan would have generated for the lender — even if you pay it off early — with a pre-computed loan.
And, this is why pre-computed loans should be avoided.
How Pre-Computed Loans Work
Viewed at a glance, simple interest loans and pre-computed loans often carry the same interest charges. In fact, when you’re using an auto loan calculator, you’ll see you’ll pay the same amount of interest — when you allow a loan to run its full course,
However, you’ll be required to provide the entire amount of interest calculated against the loan amount if you pay off the pre-computed loan early, In other words, you’ll be required to pay the full amount, even if you return to pay off the loan one day after taking it, because the interest is “pre-computed”.
The Rule of 78
Lenders can use this formula to claim a larger portion of your principal payments as interest if you decide to pay off the loan before it runs its full course — while giving the appearance of refunding you a portion of the interest payments.
Let’s consider a one-year loan term to make it easier to understand how the Rule of 78 works. The lender adds the total number of months the loan runs — in this case, one through 12, to get a total of 78. A portion of the anticipated interest amount is then allocated to each month in descending order.
Thus, you’ll pay 12/78 of the interest amount in the first month, 11/78 in the second month and so on, until the loan is paid off in the 12th month.
Your Loan Payoff Amount Will be Higher
Now, let’s say you’re about to pay off a 60-month pre-computed loan two years early. You go in expecting your payoff amount to reflect the fact that you’re paying early, only to be told you’re responsible for the full interest amount.
However, out of the goodness of their heart, the lender is willing to give you a “rebate” for the additional 24 months of interest payments based upon the Rule of 78s. Applying the algorithm, the lender can shift a more significant amount of your previous payments to interest — which will leave you with a higher than expected principal payoff amount.
What’s more, the earlier you try to pay the loan off, the more exacerbated the effect becomes. Worse, the interest rate will likely be higher because these loans are typically imposed upon borrowers with lower credit scores. This serves to diminish the number of your payments going to reduce the principal even more.
And ultimately, this is why pre-computed loans should be avoided.
Always Ask About Pre-Payment Penalties
The key question to ask when accepting any type of loan is whether pre-payment penalties are levied.
Read the agreement carefully, looking for terms such as “pre-computed interest”, “refunds” or” rebates” of interest. You also want to take note of how pre-payments of the principal are handled. If the agreement says they’ll be subject to the Rule of 78, look for another lender.
The presence of any of the above language is generally a sign you’re dealing with a pre-computed loan. By the way, the fact that pre-computed loans are most commonly offered to sub-prime lenders doesn’t mean you should relax if you have a strong credit score. You can be had just the same. Always read loan contracts carefully and insist upon simple interest loans before affixing your signature.
You’ll have little recourse but to pay once you’ve signed.