Precomputed Interest

Full definition

Most personal loans today use simple interest, where interest accrues daily on the outstanding principal balance. Precomputed (or add-on) interest works differently and is less favorable to borrowers who want to pay off early. How add-on interest works: The lender calculates the total interest for the full loan term upfront (principal x rate x years = total interest) and adds it to the principal. The resulting sum is divided by the number of payments to produce a fixed monthly payment. Example: a $5,000 loan at 10% for 3 years = $1,500 total interest. The total owed is $6,500, divided by 36 months = $180.56/month. The real APR: The nominal add-on rate is not the true APR. Because you are repaying principal throughout the loan term (so you have access to less and less of the original amount), the effective APR on an add-on loan is roughly double the stated add-on rate. A 10% add-on loan has an effective APR of approximately 18-19%. Rule of 78s: Historically, precomputed loans used the Rule of 78s method to calculate early payoff rebates. Under this method, more interest is allocated to the early months of the loan, meaning an early payoff returns less of the prepaid interest to the borrower. Some states have restricted or banned Rule of 78s calculations for longer-term loans because of this bias against early payoff. Where you still encounter it: Some auto dealers, some credit unions, some consumer finance companies, and some online installment lenders use add-on interest structures. It is much rarer on prime personal loan products from large online lenders, which almost universally use simple interest. How to spot it: Look for 'add-on rate,' 'precomputed loan,' or 'Rule of 78s' in the loan agreement or TILA disclosure. The Regulation Z APR disclosure will show the true effective APR regardless of the rate structure used, which is why comparing APRs is always more informative than comparing stated rates.

• Simple Interest
• Prepayment penalty