What is pre-calculated interest and why should you avoid it
Pre-calculated interest is an uncommon way of calculating interest on an auto loan that benefits the lender. Rather than spreading the interest evenly over the term of the loan, the interest is pre-loaded.
Ultimately, there is little difference between simple interest and pre-calculated interest auto loans if you make minimum payments. And you’ll still get money if you pay off your car loan sooner, but it’ll be less than with a simple interest car loan.
How a precalculated interest car loan works
“Pre-calculated” means that the lender calculates the interest you will pay over the term of the loan. It then adds this interest to the principal and divides it into monthly installments, like standard auto loans that use simple interest.
You will receive an interest rate and an annual percentage rate (APR) which includes all additional fees. Basically, precalculated loans are the same as simple interest loans. The way interest is calculated benefits lenders if you prepay, but if you don’t, you probably won’t notice anything special about a pre-calculated interest car loan.
The rule of 78
Lenders are not legally allowed to charge you interest that has not accrued. But they can change how interest is spread over the life of a loan.
The rule of 78 is one of the main tactics – and the basis of pre-calculated interest auto loans. The name comes from adding all the digits of the year, then applying interest in reverse order. You will pay 12/78 of the interest due the first month. The second month is 11/78, the third month is 10/78 and so on.
By charging interest like this, you’ll pay more at the start of your loan. This means that you can get an interest discount if you pay off your loan early, but it won’t have a significant impact on the overall cost.
Pre-calculated interest vs simple interest
While pre-calculated interest takes precedence over what you pay, simple interest divides the interest paid equally. This means that paying more than the minimum payment reduces the principal, which means you pay less interest the following month.
If you only make the minimum payment, there will be no difference between these two ways of calculating interest. But if you’re thinking of trying to pay off your auto loan quickly, simple interest loans are the best bet.
Advantages and disadvantages of pre-calculated interest
Pre-calculated interest is only a disadvantage if you want to repay your loan early. Otherwise, it will cost you the same as a simple interest loan.
- Since pre-calculated interest benefits the lender, it is 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 can still be approved for a precalculated interest loan.
- There is no difference in the amount of interest you pay with a pre-calculated interest car loan. By following the minimum payment schedule, a precalculated interest loan is exactly the same as a simple interest loan.
- The main disadvantage of pre-calculated interest is the prepayment. You’ll pay more interest if you pay off your loan sooner, which means less savings to be financially responsible.
- Since lenders can only use pre-calculated interest on loans less than 60 months old, you may have higher monthly payments. This means you pay less interest overall, but if you only qualify for a pre-calculated interest auto loan, it can make your loan more expensive month to month.
Why you should avoid pre-calculated interest auto loans
In general, simple interest is the best option for almost all borrowers. Even if you don’t plan to repay your loan early, your situation could change. And if so, a simple interest loan means you’ll pay less overall.
Since pre-calculated car loans take the interest you will pay, you will 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.
Pre-calculated interest auto loans are avoidable, but they’re also 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.