What is pre-computed interest?
Pre-Computed interest is a method of calculating loan payments by taking all the interest that will be due over the term of a loan and adding it to the principal amount of the loan. The sum of the principal and interest over the life of the loan is called the â€œAccount Balance.â€ Each monthly payment on a pre-computed interest loan is determined by dividing the Account Balance by the number of scheduled loan payments.
Precomputed Interest vs. Simple Interest
In a simple interest loan, each payment is credited:
- In part to pay the interest due on the principal amount at the time of payment; and
- In part to pay down the principal amount.
Because each payment on a simple interest loan reduces the principal amount, when time comes for the next payment, the principal amount is lower than at the earlier payment. Therefore, less interest is due on the principal amount and more of the payment goes to paying down the principal even further. This is the way most mortgages and personal installment loans work.
In a pre-computed interest loan, each payment is credited:
- To pay down the Account Balance.
There is no separate calculation of interest and principal amounts on a pre-computed interest loan because all the interest and principal was combined into the Account Balance at the time the loan was made.
Why do I care about precomputed interest vs. simple interest?
Well, you might not. If you make every payment on time, and donâ€™t prepay any part of the loan, the payments on a simple interest loan and a pre-computed interest loan are exactly the same.
However, if you think you might prepay the loan, you care in a big way. And hereâ€™s where we get a bit more complicated with the financial engineering.
When you prepay a simple interest loan, you pay off the remaining principal balance and any accrued interest. Remember we said that each payment reduces the principal balance of a simple interest loan, and that interest is calculated based on the reduced principal balance? Well in a prepayment, the principal balance becomes $0, so the interest due next payment is $0, too. Youâ€™re done. The loan is paid off and no more interest accrues.
When you prepay a pre-computed interest loan, you are paying off all of the â€œAccount Balance.â€ (Remember the Account Balance has all the principal and interest on the loan added together.) So when you prepay, you are entitled to a â€œRefundâ€ of the interest charges that have not been â€œearnedâ€ by the lender â€“ because you didnâ€™t keep the money for as long as they thought you would when they pre-computed your interest.
Hereâ€™s why you care. In a pre-computed interest deal, the methods used to determine your â€œRefundâ€ of unearned interest charges (including an arcane formula called â€œThe Rule of 78sâ€) results in most of the interest charges being deemed â€œearnedâ€ very early in the loan term. These calculations get so complex, that the State of Indiana (the state where many think the Rule of 78s started), explains it here: http://www.in.gov/dfi/2602.htm
In Indianaâ€™s example, they compare prepaying two 24 month 21% interest loans. Both loans are originated on January 10, 2000 and prepaid the following November 11, 2000:
A simple interest account with the same terms which was paid on the contracted due date each month and prepaid on 11/11/00 would have finance charges earned of $737.10, the unearned finance charge would be $429.22 (earning on for 10th month plus one day’s interest) which is $75.48 less total finance charges then the precomputed account [$812.54]â€¦
From the examples given, you can see that if you make your payments as contracted each month and prepay your account, a simple interest account will cost you less than a precomputed account.
Federal law prohibits pre-computed interest using the Rule of 78s in any loan with a term of more than 61 months. 17 states ban such loans entirely.
Full disclosure: Mark Lorimer has been a corporate lawyer (currently in recovery), a Public Company CEO, a private investor, and was the CMO at CAN Capital from 2006-2012 (where he also led the teams responsible for Asset Management, Revenue Speed, Collections and Legal Collections). Currently, he serves as the CMO of LendingPoint. All opinions expressed are his, and do not reflect the opinions of LendingPoint. LendingPoint makes simple interest loans.