Question on paying down loans

[Roy D Mercer]

He first needs to know what type loan he has. Simple interest or Rule of 78

Found this on the net

Occasionally on The Money Show (FM 96.9, WTKK Boston), Rick Shaffer mentions the Rule of 78 in connection with auto loans but declines to explain it in detail because it is too complicated. As an occasional listener and a person who had one of these loans back in 1983, I thought I would make a stab at explaining it...

The standard loan is called "simple interest". You borrow some money and at the end of the period you pay it back plus interest. For longer term loans, you make periodic payments. With some consumer loans, especially with auto loans, you may encounter a different type of loan which mentions the "Rule of 78". It is a different way of deciding how much of each monthly payment is interest and how much is principal.

If you don't terminate the loan early, simple interest loans and Rule of 78 loans will be equivalent. You will pay the same amount and get the interest rate quoted. However, if you pay off the loan early, you will end up paying more interest with a Rule of 78 loan than with the corresponding "simple interest" loan. For that reason, you should not take loans computed on the "Rule of 78".



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Here is a simple auto loan with round numbers:

Amount of loan: $10,000
Interest rate: 12% a year (which is 1% a month)
Length of loan: 1 year (12 months)

Simple interest says that after one month has gone by, you have borrowed the $10,000 for 1/12 of a year and you own interest of 12%/12 or 1% which is $100. The rest of your payment goes to decreasing the principal.

The next month you have borrowed $9211.51 for a month and own $92.12 in interest. After paying the interest, the rest of your payment goes to pay off the principal you borrowed.

Figuring out the payments for a simple interest loan is a job for a loan calculator. In our example, it says that the monthly payment is $888.49.

Over the life of the loan you will pay $661.85 in interest.

On the last payment you make, you will have borrowed $879.67 for one month and owe $8.80 in interest. Notice that your final payment is almost all repayment of principal.

If you look at each interest payment, it decreases each month. If you graphed the monthly interest payments, they would form a slight curve.



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OK, now let's do the same loan as a Rule of 78 loan:

Amount of loan: $10,000
Total interest due: $661.85 (same as above)
Monthly payment: $888.49 (same as above)
Number of payments: 12
Sum of the integers from 1 to 12: 78 (the magic number)

First month's interest: 12/78 times $661.85
Second month's interest: 11/78 times $661.85
Third month's interest: 10/78 times $661.85
...
Last month's interest: 1/78 times $661.85

If you were to graph the interest payments, they would form a straight line.

If you were to pay the loan off early, you would have to pay a little extra because the initial payments attribute too much to interest, and too little to principal.

How much does it matter? In our example, the worst it would matter is month 5 where the difference between simple interest and Rule of 78 is $4.01. However, our example was chosen to have round numbers and a 1 year loan.

How much does it matter in a typical auto loan? Consider the following:

Amount of loan: $30,000
Interest rate: 7.3% a year
Length of loan: 4 years (48 months)
Monthly payment: $722.57

If you pay this loan off early, you will always pay more with a Rule Of 78 loan than with a simple interest loan. Between months 7 and 29 you will be paying at least $46 more. Month 17 has you pay $66 more. Is $46 - $66 real money to you?

[BrianL]

Assuming it is a normal simple interest loan, not a split rate or other type, all interest due is paid when you make your regular payment. On that day there is $0 interest due, so any additional amount paid will automaticly go to principle. You can do bimonthly payment, but more can go wrong. Some systems don't allow it, and are carried in an escrow and applied at the next payment due date, some places they total extra payments and they are posted at year end. Most are just applied by the teller that takes them in as a regular payment. Not all tellers can post principle only transactions like that for compliance reasons. A 700.00 payment once a month will payoff with less interest paid than a semi monthly at 350, but both are almost the same in interest paid.

This is much different than a every two weeks payment. Different deal on those. For other type loans other than simple interest, different stuff applies, but those are getting fewer.

[jmm83164]

Paying off a loan to soon will lower your crediit rating. Remember credit ratings arent for your benefit they are for the banks. Paying off loans in advance means they lose money.
Thus making you a less desirable customer.Take your money and buy something real with it.

[flywise]

Paying off a loan to soon will lower your crediit rating. Remember credit ratings arent for your benefit they are for the banks. Paying off loans in advance means they lose money.
Thus making you a less desirable customer.Take your money and buy something real with it.

paying off a loan early saves money, maybe lots and lots of money

[Stan R]

All federal student loans are simple interest. Most private student loans are simple interest.

All student loans federal or private are supposed to not have any prepayment penalty.

Federal regulations allow the lender to apply a prepayment to "future installments by advancing the next payment due date" unless otherwise specified by the borrower.2 For this reason it is important to include a note with any prepayment indicating that you want the prepayment applied to reduce the principal balance of the loan. Otherwise, the lender will treat it as though you had paid your next installment(s) early, and may delay the next payment due date(s) as appropriate.

[Ohio Darin]

My wife was told by the holder of her student loan that she could not make principle only payments.( where any extra payments should be made). and that there was an early payoff penalty.
Good ( extra payment calculator ) I am toying with this on a few little loans I have

A lot of early pay off penalties are a percentage of the unpaid balance. If this is the case you can pay all but say $100 and the final month pay the balance plus the penalty computed on $100 which would be $2 for 2%.

Same works if the loans has a fixed fee amount if paid before so many months. Pay all but $100 (or one last payment amount) then divide the remaining $100 by the amount of months and then pay that portion each month. You save the interest and avoid the prepay penalty. I actually had a loan like this but they made me keep one payment amount left. I divided that amount by outstanding months and paid the portion. When I got the statements it showed the pay off and penalty amount each month but I just kept paying the small monthly portion until all was satisfied without penalty.

There is away around every prepay penalty - you just have to think like a banker

I forgot to mention, always write "Apply extra payment to principle" on remittance stub if there isn't a box provided.