My first job out of college was this a consumer finance company. We would make small loans to consumers at incredibly high interest rates, but I justified it as if I was actually helping people. I was a young, naïve kid and I should have known better. The interest rates we were charging sometimes approached 39%, but more important than the rate was how the interest was calculated. My company used “precomputed interest” as opposed to “simple interest”. Once a consumer goes into the precomputed interest abyss, they will struggle to get out.
What is precomputed interest? Sometimes it’s also knows as the “Rule of 78”, which better explains the concept. There are 12 months in a year, so if you ad 1 + 2 + 3 +….+12, you get 78. Precomputed interest front-loads the interest paid by the customer. In the first month of a 12-month loan, 12/78 of the total interest is earned by the lender. In the second month, 11/78 of the interest is earned and so on until, in the final month of the loan, only 1/78 of the interest is paid. For longer-termed loans, the denominator will change to reflect the loan term. For instance, you would add 1 through 36 for a 3-year loan. In that first month, the numerator would be 36 and in the final month, the numerator would be 1. In a precomputed interest loan, half of the interest is paid in the first one third of the loan term. The finance company will start calling about 1/3 of the way through the loan to refinance the loan to get you a lower payment. It allows them to start the calculation all over again thereby earning a lot more money.
The US government has long since outlawed the practice for loans over 5 years. It’s important that you pay attention to how interest is calculated in your loans that you use to finance your real estate investments. Be sure you are getting “simple interest” as opposed to “precomputed interest.”