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Guide to Precomputed Interest Car Loans

What Is a Precomputed Interest Car Loan?
Austin Kilham
Austin KilhamUpdated April 13, 2023
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Interest is the amount of money you pay to borrow money. For auto loans, interest can be calculated in different ways, including simple interest and precomputed interest. A precomputed interest car loan is relatively uncommon. Still, it’s wise to know what these loans are and how they work in case you’re ever offered a precomputed loan. 

What Is Precomputed Interest? 

Precomputed interest is one of the ways lenders can use to calculate car loan interest. With precomputed interest, the lender determines how much interest you would pay over the course of the loan if you only made the minimum payments each month. They take that amount and add it to your loan principal to come up with the balance you owe, and then divide the total into monthly payments. With precomputed interest, the interest is highest at the beginning of the loan. If you pay off your car loan early, the lender makes more money and your savings may not be as great. How interest works on a car, typically, is that auto loans are calculated using simple interest. But some lenders, especially those who specialize in working with borrowers with bad credit, may favor precomputed interest.  

Precomputed Interest vs Simple Interest

With simple interest car loans, the interest is calculated based on the balance of your loan on the payment due date each month. As your loan balance shrinks, less money goes to interest payments, and more goes to paying off your principal. If you make extra payments to reduce your principal faster, you’ll pay less interest over the life of your car loanThe basic difference between precomputed interest loans and simple interest is that with precomputed interest, you pay more interest at the beginning of the loan. With simple interest, the interest is based on your loan balance, and what you pay in interest goes down over time.Recommended: 9 Tips on How to Shop for Auto Loans

Calculating Precomputed Interest

A precomputed loan is calculated on a 12-month loan using what’s known as the Rule of 78. The rule gets its name from adding together all the months in a year:1+2+3+4+5+6+7+8+9+10+11+12=78 The lender gives each of the 12 months a portion of the total interest owed, with the biggest share in the first month, and then descending from there. So the first month gets 12/78 of the interest, the second month gets 11/78, and so on, until the last month is assigned 1/78 of the interest.A precomputed interest car loan with a 24-month term uses a similar formula for precomputed interest. The lender adds up all the numbers from 1 to 24, which equals 300. The first month of the loan gets 24/300 of the interest, and then goes down from there. This means if you pay off your loan early, the lender makes more money. For the borrower, the savings are considerably less with a precomputed loan than they would be with a simple interest loan. The Rule of 78 is controversial. Its use is banned in some states, and other states put heavy restrictions on it. By law, lenders are not allowed to use the Rule of 78 on loans longer than 61 months. 

Example of Precomputed Interest

Precomputed interest can be complicated. To get a sense of how it works, let’s say your principal and interest payments for a 12-month auto loan total $5,000, and your monthly payment is $500. With precomputed interest and the Rule of 78, your payment would look like this:
MonthStarting amountInterestPrincipalEnding Balance
As you can see, the interest you pay is much higher at the beginning of a precomputed interest car loan than at the end. If you have an auto loan with precomputed interest, and you’d like to change it, you could consider an auto loan refinance to get a new loan with simple interest. Recommended: How Soon Can You Refinance a Car Loan After Purchase?

Pros and Cons of Precomputed Interest Car Loan

If you’re making your regular payments over the life of the auto loan, precomputed interest won’t be much different than simple interest. You’ll pay the same amount in interest overall, but it will be applied differently.And for borrowers with bad credit, a precomputed loan may be easier to qualify for.However, if there’s any possibility that you’ll pay off your car loan early, you may want to avoid precomputed loans. Even though lenders technically have to refund you interest that hasn’t yet been earned on the loan, with a precomputed loan, you’ve paid more interest early. As a result, you’ll get less interest back when you prepay a precomputed loan than a loan with simple interest.  In addition, by law, precomputed loans can’t be longer than 61 months. That term could make your monthly payments higher than a loan with a longer term.
As long as you make your regular minimum monthly payments, you’ll pay the same amount of interest over the life of the loan as you would with a loan that has simple interest.If you prepay your loan, you’ll end up paying more in interest, and your savings will be less.
Borrowers with bad credit may find precomputed loans easier to qualify for.The longest loan term you can get, by law, is 61 months, which means your monthly payments could be higher.

Refinancing a Precomputed Loan 

If you get a precomputed interest car loan, you may want to consider refinancing it. When you refinance a loan, you pay off the old loan and get a new one, ideally one with a good auto loan interest rate or a longer term. When refinancing, you could look for a loan with simple interest rather than a precomputed loan.If you qualify for an auto refinancing loan with more favorable terms, it could help lower your monthly payment. Generally, the better your credit, the lower the interest rate you’ll get. If you’re thinking about refinancing, one of the tips for auto loan refinance is to be sure to make all your bill payments on time which could help strengthen your credit so that you might be able to qualify for a lower rate.

The Takeaway

With an auto loan with precomputed interest, you’ll pay more in interest at the beginning of the loan term and potentially lose out on savings if you repay the loan early. A loan with simple interest may be best for many borrowers. However, weigh the pros and cons to determine what makes the most sense for your specific situation. And remember, you don't have to keep a precomputed loan if it’s not working for you. In that case, you can explore auto loan refinancing. Lantern makes the process easy by connecting you with multiple lenders at once so you can compare rates and terms to find the best auto loan refinance option for you. 

Frequently Asked Questions

Are car loans simple or precomputed interest?
Can I pay off a precomputed loan early?
What is the difference between simple interest and precomputed interest?
Photo credit: iStock/fotolgahan

About the Author

Austin Kilham

Austin Kilham

Austin Kilham is a writer and journalist based in Los Angeles. He focuses on personal finance, retirement, business, and health care with an eye toward helping others understand complex topics.
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