When taking out an auto loan, understanding the difference between simple interest and precomputed interest is essential, especially if you plan to pay your loan off early or make additional payments along the way.
Simple Interest Rate
Simple interest is calculated based on the outstanding loan balance, either daily or monthly, and it’s the most common interest calculation method for auto loans. With a simple interest loan, the interest charges are computed only on the remaining principal balance. This means if you make extra payments or pay down your balance more quickly, you reduce the overall amount of interest you’ll pay, as your principal balance decreases faster. For example, if you make more than your scheduled monthly payment, you’ll reduce your balance sooner, and each future interest calculation will be based on this lower balance, saving you money over the loan’s term.
Precomputed Interest Rate
Precomputed interest, on the other hand, calculates the total interest you will owe over the life of the loan upfront, at the time the loan is originated. This amount is then added to the principal balance and split evenly across the monthly payments. With precomputed interest, the majority of your payment goes toward interest in the early stages of the loan. Unlike simple interest, making extra payments does not reduce the interest portion you owe, as it’s already “precomputed” and fixed into the loan. This structure benefits lenders more than borrowers, especially if you’re planning to pay off the loan early, as you may not realize significant interest savings from additional payments. However, in certain cases, lenders may issue a partial refund of any “unearned” interest if the loan is paid off ahead of schedule.
Which Option Is Better?
For borrowers who want flexibility to reduce their interest costs with additional payments or plan to pay off the loan early, simple interest is typically the better choice. Precomputed interest loans can end up costing more in interest if you accelerate payments, as the interest is set at the start and not recalculated based on your remaining balance. Checking with your lender about the type of interest calculation used can help you plan your repayment strategy effectively.
