There is one way lenders make more interest on you and that can cost you lots of money - even if you make extra principal payments.
You pay extra principal on your auto loan, but you quickly realize after several payments that your interest is not dropping as fast as you want. There's a problem. You come to find out how many auto lenders, such as some credit unions and banks, utilize a lesser-known (legal) repayment program that can easily cost you a lot of money.
We all like to payoff auto loans as soon as we can. We want to free ourselves from the monthly obligation. So, we like to pay a little more each month trying to pay the loan off early. Unfortunately, a subtle difference in loan programs can end up costing you lots of money.
There are two auto loans, both $25,000 on a 60 month repayment at a 4.00% rate. The standard payment is $460.41 over the five year period. If you elect to pay $600 a month instead, you should payoff that loan after 45 payments.
Instead of calculating the interest on the loan as simple interest, the lender calculates interest on a precomputed basis. What’s the difference?
Simple Interest Loans
Simple interest accrues on the balance of the loan. Using the previous example of a $25,000 auto loan, you elect to make your first payment $1,083.33. The interest accrued is $83.33 for the first month and the principal balance should drop by $1,000 to $24,000.
The next month, you pay another $1,083.33 to the loan. The interest is $80 on the $24,000 balance so the principal balance would drop by $1,003.33 to $22,996.67. Pretty simple.
Precomputed Interest Loans
Precomputed interest calculates interest based on the initial loan amount. Using the same previous example of a $25,000 auto loan, you elect to make your first payment $1,083.33. The interest accrued is $83.33 for the first month and the principal balance should drop by $1,000 to $24,000.
The following months is where the changes occur that will cost you more money. The second month, you pay another $1,083.33 to the loan. The interest is $82.08 on the $24,000 balance. The principal balance would drop by $1,001.25 to $22,998.75. As time goes by, this number gets bigger and that is money ou of your wallet.
Why the difference? The interest is still accruing like you still made just the regular minimum payment. It does not give you credit for paying extra on the loan. It is this way until the loan is paid off.
How much can it cost you? A lot more than you realize. That interest will add up fast even though it starts out only a few dollars. When you go to payoff the loan in 45 months of $600, the precomputed interest loan will cost you $483.44 more than the simple interest loan.
The additional note - the higher the interest rate, the more you will pay in extra interest.
What Can You Do?
Ask before you take out any loan (mortgage loans are usually simple interest). Is it a simple interest or precomputed interest loan. Look for lenders – especially auto lenders – who will offer you simple interest loans. Besides, we all don’t want to pay more than what we should. By asking, we can avoid paying several hundred dollars more.