A precomputed loan is a type of personal loan. With these loans, the lender will calculate the interest owed up front and add it to the principal balance. This is different from a simple interest loan, where interest charges are determined by the principal balance month to month.
Precomputed loans typically favor lenders, and the way the interest charges are calculated is complicated. You’ll want to have a clear understanding of what you’re signing up for before you can decide if it’s the right fit for you.
What Does “Precomputed Loan” Mean?
With a precomputed loan, the lender calculates the total interest charges that would accrue over the life of the loan and then adds it to the principal balance. Your starting balance is a combination of the principal balance and the interest charges. You still make your monthly payments like other types of loans, however, the interest charges remain the same, even if you make extra or early payments on your loan.
If you make minimum payments over the life of your loan, there isn’t much difference between precomputed loans and simple interest loans. However, with a precomputed loan, it’s harder to pay off your loan early to save on interest charges. Since your balance is a combination of interest charges and principal, you can’t specify to the lender that you want to pay more to the principal balance to pay it off faster.
If you are able to pay off the loan before the loan term ends, you must ask your lender for a refund on any “unearned interest.”
💡 Quick Tip: Before choosing a personal loan, ask about the lender’s fees: origination, prepayment, late fees, etc. SoFi personal loans come with no-fee options, and no surprises.
Simple Interest vs. Precomputed Interest
Simple interest is another way lenders calculate interest charges — it’s commonly used for mortgages, student loans, and personal loans. It’s a more straightforward way of calculating interest, where lenders multiply the principal amount by your interest rate.
When you make your monthly payment on your simple interest loan, a portion goes to paying the interest charges and the remaining amount goes toward the principal balance. At the start, you’ll be paying more in interest than principal, but as your balance gets smaller, so will the interest payments.
If you may want to pay off your loan early, a simple interest loan is a better choice because your interest is recalculated based on the shorter term.
Say that your total interest charges should be $1,200 for a 12-month loan. After nine months, you’ve paid $900 in interest, and you decide to pay off the rest of the balance in a single payment. With a simple interest loan, you wouldn’t be required to pay the remaining $300 in interest charges — that’s considered “unearned interest.”
Precomputed interest, unlike simple interest, adds the interest charged onto the principal so your total balance is a combination of interest charges and the principal balance, and you can’t tell the lender you want to make extra payment directly to the balance.
| Simple Interest | Precomputed Interest |
|---|---|
| Interest charges calculated based on the principal balance each month | Interest charges calculated at the start of the loan and added to the principal |
| You can save money in interest charges if you pay off the loan early | Not much savings if you decide to pay off the loan early |
The Rule of 78
The rule of 78 is a quirky method some lenders use to calculate interest for precomputed personal loans. First, they add up all the months in a year, represented by numbers:
| 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78. |
The lender then calculates how much interest you owe on a loan and distributes the charges by weighting the interest payments in reverse order.
The interest distribution schedule for a one-year precomputed loan would look like this:
| Month | Interest Charge |
|---|---|
| Month 1 | 12/78 |
| Month 2 | 11/78 |
| Month 3 | 10/78 |
| Month 4 | 9/78 |
| Month 5 | 8/78 |
| Month 6 | 7/78 |
| Month 7 | 6/78 |
| Month 8 | 5/78 |
| Month 9 | 4/78 |
| Month 10 | 3/78 |
| Month 11 | 2/78 |
| Month 12 | 1/78 |
With both simple- and precomputed-interest loans, you pay more interest charges at the start. But the big difference is you have the option to pay off the simple interest loan sooner without penalty. Unlike a precomputed loan, you can tell the lender you want to make extra payments toward the principal to pay down the loan faster.
Because of the way interest is distributed with a precomputed loan, there’s no incentive for a borrower to pay off their loan early.
💡 Quick Tip: Some lenders can release funds as quickly as the same day your loan is approved. SoFi personal loans offer same-day funding for qualified borrowers.
Is Precomputed Interest Legal?
In 1992, the U.S. government banned precomputed loans that use the rule of 78 on terms spanning longer than 61 months. In fact, some states have outright banned using the rule of 78 for consumer loans.
Some loans that use precomputed interest are still legal, though financial institutions rarely use them. That’s because loans that use the rule of 78 are better for lenders than for consumers. Calculating the interest charges requires a complex formula, and there’s no financial incentive to pay off the loan sooner.
Precomputed Loan Amortization
As you pay off your loan, the amount of interest you pay on a precomputed loan will get smaller with each subsequent payment. In the first month of a 12-month loan, you will need to pay 12/78 of the interest charges, the second month 11/78, all the way to the last month where you pay 1/78.
For 24-month loans, you’ll pay 24/300 of the interest charges in the first month, 23/300 the second month, and so forth until you reach 1/300.
To calculate the exact amount you’ll pay each month, you’ll need the total interest charges. Then you can divide it up into the number of payments for your term using the rule of 78.
Let’s say you took out a $7,000 loan for a 12-month term at a 7% interest rate. Assuming you’ll pay $272 in total interest for the entire loan term, here’s how the interest payments are broken down by month:
|
Amortization Schedule |
|
|---|---|
| Month | Interest Paid |
| 1 | $41.85 |
| 2 | $38.35 |
| 3 | $34.87 |
| 4 | $31.38 |
| 5 | $27.89 |
| 6 | $27.41 |
| 7 | $20.92 |
| 8 | $17.43 |
| 9 | $13.95 |
| 10 | $10.46 |
| 11 | $6.97 |
| 12 | $3.48 |
You can see by looking at the chart, your interest charges get smaller each month.
Pros and Cons of Precomputed Interest Loans
Although precomputed interest loans seem complicated, there may be some advantages to this form of debt.
| Pros of Precomputed Interest Loan | Cons of Precomputed Interest Loan |
|---|---|
| Interest is similar to a simple loan, if paid on time throughout the full loan term | There’s no financial incentive to pay off the loan early |
| Fixed interest rate | There’s no flexibility to pay off loan early |
| Typically comes with fixed payment amounts | Can be hard for borrowers to understand |
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How Do You Know If Your Loan Has Precomputed Interest?
You can look over your personal loan agreement to see if it has precomputed interest. Some clues to look for include whether it mentions refunding interest or anything about the rule of 78.
If you’re unsure, you should always contact the lender and ask them to explain how interest is calculated before you sign the contract.
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Are Precomputed Loans Bad?
Precomputed loans aren’t necessarily bad. You’ll probably pay the same interest as with a simple loan, as long as you pay on time over the entire term of the loan. These loans can be problematic if you think you may want to pay off your loan early.
If you’re trying to save on interest, and you have the means to make extra or early payments, you may be better off avoiding precomputed loans.
Alternatives to Precomputed Loans
Instead of precomputed loans, consider these alternatives:
• 0% credit cards offer cardholders an introductory period (anywhere from 6 months to more than a year) where you can carry a balance without accruing interest. You are usually required to make a minimum payment each month. If you don’t pay off the full balance by the time the intro period ends, you’ll be charged interest.
• Simple-interest personal loans are a form of installment loan. You can borrow a lump sum to be paid back with interest over the course of a loan’s term (usually a year or more). Lenders typically charge simple interest for these types of loans.
The Takeaway
Whatever type of loan you choose, it’s important to carefully examine your loan documents to ensure you understand what your responsibilities are as a borrower and how much you will be paying in interest charges.
Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.
FAQ
Is precomputed interest legal?
Yes, precomputed interest is legal, but the rule of 78 is a complicated and controversial concept that favors financial institutions. The rule of 78 is illegal for all loans over 61 months and in some states altogether.
How do you know if your loan has precomputed interest?
You can check your loan agreement to see if it mentions anything about the rule of 78 or refunds/rebates of interest charges. If you’re not sure, you should ask your lender.
What does “precomputed loan” mean?
A precomputed loan means the lender is charging you precomputed interest, which means your interest charges are added to your principal balance. The starting balance will be a total of your interest charges and principal. While you can pay off a precomputed loan early, there’s not the same financial incentive that you get when you pay off a simple interest loan early.
Photo credit: iStock/Chainarong Prasertthai
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