Always Make Sure to Get a Simple Interest Loan
When getting a car loan, there are two ways lenders can calculate the payment and interest schedule.
The most common way is called a simple interest loan, and this is the only type of loan you should ever sign. The other is called a pre-computed loan or The Rule of 78s and you need to stay far away from this type of loan.
With a simple interest loan you're charged interest each month based on the balance you owe. Your interest payments will get smaller with each payment because you're paying off the principal, and if you choose to make extra payments to pay down the balance, you'll pay less interest in the following months.
With a pre-computed auto loan, you're obligated to pay back the principal plus the total interest that will accrue over the entire term of the loan. The loan is setup so that the majority of your interest is paid off early in the loan. If you later decide to pay off the loan early or refinance, you will be stuck paying a huge amount of interest.
Luckily, most car loans these days are computed using a simple interest formula and some states even outlaw the Rule of 78s method. However, it doesn't mean you can rest easy - many sub-prime lenders still use the pre-computed loan method so if you have bad credit, you really need to pay attention.
In order to determine if it's a pre-computed loan, first check the front of the contract to see if it allows a refund or rebate of interest. If it does, you're signing a pre-computed loan.
On the back of the agreement, look under the prepayments section to see if the Rule of 78s formula is mentioned. Most lenders don't include this information but sometimes you can spot it.
If it's too late and you already signed a pre-computed loan, then your best option is to just keep paying off the loan until it's complete.
Each week, I'll keep you up-to-date on the latest car deals and news that might affect your purchase. This includes...
- Best Rebates, Incentives, and Lease Deals
- Latest Car Buying Scams and Tricks
- The Best & Worst Time to Buy a Car
- Which Cars You Should Avoid