by Kailey Hagen | Updated Sept. 7, 2021 - First published on Oct. 12, 2019
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Promo: Hint: It's another trick lenders use to line their pockets at your expense.
You probably pay attention to the interest rate when you apply for a loan, and if you're smart, you also check for prepayment penalties to make sure you won't get hit with extra fees if you decide to pay your loan off early. But there's another thing you should look into before you sign on that dotted line -- how the lender applies payments to your balance.
Most loans today are simple-interest loans, where part of each payment goes toward the principal and part goes toward the interest. As your principal balance shrinks, so does the amount of interest you pay every month because the interest is calculated based on your current principal balance. When your principal reaches zero, there's no balance left to accrue interest and you're done paying off the loan.
Precomputed loans work a little differently and they can be costly to those who plan to pay off their balance ahead of schedule. Here's how they work.
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Precomputed loans don't allocate a portion of each payment to the principal and a portion to interest like simple interest loans. Instead, they calculate the total interest you would pay for the whole loan term if you made the minimum monthly payment as if were a simple-interest loan. This is added to your principal to get your account balance. Each payment you make reduces your account balance until you reach zero. If you pay the minimum amount every month, the cost ends up being similar to what you'd pay with a simple interest loan.
But if you want to pay your loan off early it is not so simple. In theory, the lender must refund you any interest it hasn't "earned" because you didn't hold onto its money as long as expected. It sounds like it's just a different way of doing things that should cost you about the same amount as a simple-interest loan, but it's not and that's all thanks to the Rule of 78.
This arcane formula determines when lenders are considered to have "earned" the interest you're paying on your loan. It heavily favors the lender and is so controversial that the federal government banned lenders from employing this strategy for loans longer than 61 months, and 17 states have banned it outright.
It's called the Rule of 78 because that's the sum of all the digits of the months in a year (1+2+3+4+5+6+7+8+9+10+11+12). Each month of the loan is assigned a portion of the interest in reverse order. So in the first month of a 12-month precomputed loan term, the lender earns 12/78 of the interest. In the second month, it earns 11/78 of the interest, and so on. If you have a longer loan term -- say 24 months -- you would calculate it the same way as above, but you would total up the numbers 1 to 24 to get 300. In your first month, the lender would earn 24/300 of the interest, 23/300 in the next month, and so on.
The model is set up so that most of your interest is considered "earned" early on in the loan term. When you try to pay back your loan early, you will get a refund, but it will be less than it would have been for a simple-interest loan because the lender is able to lay claim to more of your interest more quickly.
To help you get a sense of how precomputed loans work, let's consider a $10,000 loan with a 6% APR and a five-year loan term. If you made the minimum payment every month of the loan term, your final cost comes out about the same no matter which loan type you have. You'd pay $1,600 in interest in either case.
Now let's imagine that after two years, you decide you want to pay your loan off. At that point, you would have paid in about $995 in interest if you had a simple-interest loan and your remaining balance would be $6,355. If you pay off the $6,355, there is no principal balance left to accrue interest and your loan is considered paid off. You would save yourself $605 in interest that you would have paid had you taken the full five years to pay back what you borrowed.
With a precomputed loan, your remaining account balance would be $6,378 after 24 months and you would've paid $1,018 in interest to date, due to the Rule of 78 stacking the earned interest at the beginning of the loan term. That means you'd only save yourself $582.
This difference gets more extreme if you pay the loan off earlier or if you borrow a larger amount of money.
Precomputed loans aren't any more expensive than simple interest loans if you plan to make minimum payments. But if you think there's a chance that you'll make extra payments here and there or pay off your loan ahead of schedule, you don't want to get saddled with a precomputed interest loan.
Fortunately, this isn't something most people have to worry about. Precomputed loans are pretty rare. You typically find them on auto loans for borrowers with subprime credit. Some personal loans use a precomputed model as well.
The most important thing is to read through any loan agreement before you sign up. It may not be called a precomputed loan and it may not mention the Rule of 78. Look for mentions of an interest refund or rebate, or you could ask the lender directly if you're dealing with a precomputed loan. If you are, consider negotiating for a simple-interest loan or apply for a loan with another lender instead.
If you already have a precomputed loan and didn't realize it, make your payments on time and on schedule. You can pay off the loan early if you want, but you won't get much benefit from doing so. Refinancing isn't going to help you either because your new lender will consider the precomputed interest part of your new balance, so you'll still have to pay it.
Loans can be complicated and it pays to understand how yours work, especially if you think you might try to pay it off ahead of schedule. Read the fine print to make sure you're not dealing with a precomputed loan and keep shopping around if you are.
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