You have just secured a competitive interest rate on an upcoming truck purchase. Think your work is done? Think again, because it is really just beginning. The interest rate, deservedly so, receives the most attention. But did you know that the interest calculation your lender uses could affect your financing costs?
Have you ever wondered how much of your monthly truck payment is applied to interest and how much goes to actually paying off the truck? In order to know this, you have to know what interest calculation method your lender uses. This is easier said than done, because the interest calculation or prepayment method used by the lender is usually not clearly defined in the finance document.
There are two primary methods lenders use to calculate interest. Let's first examine the "simple interest" method. As the name implies, this method is "simple" in concept. The thing to remember is that interest is paid only on the original amount borrowed for the length of time you have use of the money. The simple interest method is also referred to as the "declining balance" method, since you only pay interest on the amount of the principal that has not yet been repaid.
Let's forget about "simple" for a moment and turn our attention to precomputed interest. Does the "Rule of 78s" method ring any bells or send chills down your spine? Even though this is the method most commonly applied to truck and trailer loans, it is not widely understood. Despite not understanding this method, most view the Rule of 78s method negatively. As well they should, because this method charges more interest early in the term of the loan and less later. Despite what you might have been told, this method almost always benefits the lender in the case of an early payoff.
There is much confusion surrounding the Rule of 78s. It's hard to separate fact from fiction. Even the name is confusing. For starters, how did it come about? This method gets its name from the fact that if you add the sum of the digits representing the months in a calendar year (1 to 12) the answer is 78. When you think about it, this makes perfect sense.
The biggest myth associated with the Rule of 78s is that you pay all the interest regardless of when you might prepay the loan. The Rule of 78s is also commonly thought of as a prepayment penalty, which is not technically the case. In most cases, an early loan payoff will be higher under this method compared to the simple interest method. Because of that, most assume a penalty was added.
Now for the method behind the madness of the Rule of 78s. Under this method, you would pay 12/78 of the total interest charge the first month, 11/78 the second month, and so on for a 12-month loan. When dealing in longer loan terms, the method is the same, however, the sum of the digits increases. For instance, a 24-month term would allocate 24/300 of the total interest charge to the first payment. The 300 is the sum of the digits 1 to 24. Again, this makes sense, but I am scratching my head, wondering who could've dreamed this up.
Most borrowers understand that their payment is made up of two parts: interest and principal. Beyond that, it's usually a mystery. Adding to the confusion is the fact that the interest calculation method is somewhat invisible. Your actual monthly payment is the same regardless of the method used. Even the amount of interest paid over the life of the loan is the same if all payments are made as scheduled.
What happens to that monthly payment behind the scenes however, is very different. How much of your payment that is applied to interest and principal depends on the method used. For the sake of comparison, lets say you have a $100,000 truck loan at 9.00 percent APR for 60 months and your payment is $2,075.84 per month. The interest portion of your first payment under the simple interest method is $750.00 compared to $804.93 under the Rule of 78s method.
As you can see from this example, the simple interest method applied nearly $55.00 more to actually paying of the truck. Let's assume you decide to pay off or trade your truck the day after you made the 21st payment. Assuming the lender received all 21 payments when due and there is no prepayment penalty, your payoff using the rule of 78s method would be $527.10 higher than the simple interest method.
You might be wondering, how can the rate be 9.00 percent APR in both cases when one payoff is higher than the other one? Remember I mentioned earlier that under the Rule of 78s method the lender earns more of the interest charges in the early months of the loan. The flaw with the Rule of 78s method is that it assumes that all 60 payments will be made, which is the exception and not the rule.
To illustrate this point one step further, the actual annual percentage rate paid under our early payoff example would be 9.30 percent APR under the rule of 78's method and not 9.00 percent APR. Since the simple interest method calculates interest on the declining balance, your annual percentage rate would still be 9.00 percent, despite the fact you made an early payoff. At no time does the Rule of 78s method yield a payoff lower than the simple interest method using the example cited above. Since most loans never go full term, you can see how the Rule of 78s method benefits the lender.
You can bet that if the interest calculation or prepayment method is not clearly defined, it's probably the Rule of 78s method. Don't be fooled by its aliases: The "precomputed interest" method and the "sum of the digits" method. Also, be aware that "prepayment penalties" or "prepayment premiums" are separate and can be applied to both methods. If in doubt, check it out!