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Guide to Precomputed Interest Loans

Guide to Precomputed Interest Loans
Lauren Ward
Lauren WardUpdated September 20, 2022
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
A precomputed loan calculates the interest on a loan up front instead of having it accrue between payments. That interest is added to the principal balance.With a precomputed loan, all interest calculations are made, assuming the borrower is going to pay the minimum monthly amount for the duration of the loan term. This means that borrowers who want to pay off their loan early may not save any money on interest.Read on to find out how a precomputed loan works, how it’s determined, including precomputed interest, and whether this type of loan is a good fit for your needs. 

What Is Precomputed Interest?

Precomputed loans use what’s known as the Rule of 78 to determine how much interest a borrower pays each month of a 12-month loan. It’s called the Rule of 78 because adding the numbers of the 12 months in a year equals 78: 1+2+3+4+5+6+7+8+9+10+11+12= 78Lenders allocate an amount of interest for each month of the loan. The catch is that it’s done in the reverse order — meaning the first loan payments are heavier in interest than the last. The first payment accounts for 12/78 of the total interest a borrower would pay, the second payment accounts for 11/78 of the total interest, and so on. The same computation method is used for longer loans, too. For example, a two-year loan would have a first monthly payment that accounts for 24/300 of the total interest paid (300 being the sum of all digits between 1-24, the number of months in two years). The second month would account for 23/300 of interest, and so on.

How Does a Precomputed Loan Work? 

Like most loans, with a precomputed loan, the borrower has fixed monthly payments and a percentage of each payment goes toward both the principal and the interest. However, the difference with a precomputed loan is that the first payments will have higher interest than the last. 

Precomputed Loan vs Simple Interest Loan

With a simple interest loan, the interest is computed by multiplying the current principal amount by the interest rate. The monthly payment fully pays off any interest that has accrued, and the rest goes towards the loan’s principal. As you pay down your principal, less interest is assessed.Precomputed interest, on the other hand, calculates up front how much interest a borrower will pay if the loan extends through the entire loan term. The total amount is added to the principal to create the balance. The monthly payment is calculated by dividing the new balance by the number of payments. The amount of interest for each payment is then determined using the Rule of 78. Precomputed loans aren’t common and they’re typically short term loans. Paying off debt is much easier if you understand what type of interest your loan has. If you can’t locate that information, call your lender and speak with a loan officer.   Recommended: Refinancing Personal Loans: How & When To Do It

Is Precomputed Interest Legal?

Precomputed interest on its own is legal. The Rule of 78, however, is complicated and controversial.In some states, the Rule of 78 is banned. In others, it has many restrictions on it. In 1992, the federal government prohibited lenders from using the Rule of 78 on loans more than 61 months in length in all 50 states.  

How Do You Know If Your Loan Has Precomputed Interest? 

The best way to determine if a loan has precomputed interest is to refer to the loan agreement. If there is any wording about the Rule of 78 or an interest refund or rebate, then you may have a precomputed loan. If you’re still unsure, call the lender and speak with a loan officer. 

Calculating Precomputed Loans

Lenders of precomputed loans should provide borrowers with a payment schedule that lists how interest is distributed over the life of the loan. If they don’t, there are many online payment calculators to help you.

Precomputed Interest Formula

Here’s how to calculate the precomputed interest assuming $200 in interest over the course of a year-long loan:Total interest paid x number of payments ÷ sum of the number of paymentsExample: $200 x 12 ÷ 78 = $30.77This amount would be the first monthly payment of a 12-month loan. The total interest paid is $200 over the course of one year. This amount does not include the loan’s principal.

Precomputed Interest Example

Let’s say a borrower takes out a $1,000 personal loan for debt consolidation. If the loan term is 12 months, and the APR is 20% (meaning the total interest paid is $200), here’s what the payment schedule would look like with a monthly payment of $100.00 using the Rule of 78 for a precomputed loan:In the beginning, the interest payments are higher than they are in the end. However, by the twelfth payment, a majority of the monthly payment goes toward the principal instead of the interest. 

Precomputed Loan Late Payments

A lender may charge a separate late fee for making a payment after the due date. That means you’ll have to pay a late fee in addition to your regular monthly payment. Another option might be that part of your next monthly payment goes toward the late fee and the rest goes towards the loan principal. Be aware that if you miss too many payments, your loan will go into default. When this occurs, the lender may turn your loan over to a collection agency.  

Paying off a Personal Loan Early

If you pay off a loan with precomputed interest early, you may receive money back as a refund, but it will likely be less than it would have been if you’d had a simple interest loan. That’s because with a precomputed loan, you pay more interest early in the loan term. 

Types of Personal Loans

When you’re taking out a personal loan, there are five personal loan types to choose from:
  • Unsecured personal loan: Also called a no collateral loan, an unsecured personal loan does not require any collateral to secure it. That means any assets the borrower has in their name are not at risk if they default on the loan. 
  • Secured personal loan: A secured personal loan requires collateral to back it. The benefit of collateralized loans is that they often come with lower interest rates than unsecured personal loans. 
  • Variable rate loan: When index rates change, so do the interest rates on  variable rate loans. These loans help borrowers save money if and when rates drop. 
  • Fixed rate loan: A fixed rate loan comes with an interest rate that is set and doesn’t change. Fixed rate loans can make budgeting easier because the monthly payments are always the same. They also protect borrowers from rising interest rates.
  • Personal loan with a cosigner: With this type of loan, a cosigner on the loan agrees to continue the payments should the primary borrower be unable to do so.  

The Takeaway

Loans with precomputed interest have their interest calculated upfront. They use something called the Rule of 78, a practice that makes the interest payments at the beginning of the loan higher than the payments at the end. Make sure to read any loan agreement carefully before signing it so that you are aware of the terms. Exploring loan options can help you find what makes the most sense for your needs. With Lantern you can easily and conveniently compare loan terms and interest rates for multiple loans at the same time and in the same place.
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Frequently Asked Questions

Is precomputed interest legal?
How do you know if your loan has precomputed interest?
What does precomputed loan mean?

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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