Interest is the price paid for the use of borrowed money – a fee paid to a lender by a borrower. The two most common types of interest calculation methods used in the Buy Here Pay Here industry today is Simple Interest and Add On Interest (Rule of 78’s).

With a simple interest loan, interest is charged daily (per Diem) on the unpaid principal balance. The daily rate is calculated by multiplying the principal balance by the interest rate and dividing that by 365 days. For example, Tommy finances a car for $12,000 at 10% APR: $12,000 x 10% / 365 = $3.29 per day. Next we must determine the number of days interest is owed at the time of payment. Let’s say he bought the car on July 9th and makes his first payment on August 8th. He would owe 30 days of interest or $98.70. He makes his regular payment of $350, so principal is reduced by $251.30. Interest will be calculated on $11,748.70 at his next payment thus reducing the daily rate to $3.22.

The simple interest method rewards customers that pay ahead – the quicker you pay down the loan the less interest you pay. In contrast, if payments are not made on time, the customer will pay more in interest over the life of the loan than the finance charge disclosed on the retail installment contract.

An Add On Interest (Rule of 78’s) loan, also referred to as a precomputed loan, is where interest is determined at the beginning of the loan and added onto the principal. If Joey borrows $12,000 and the precomputed finance charge is $1,200, he will owe the lender $13,200 at the time the loan is made. Each full payment collected is subtracted from the $13,200 balance. For a 12 month loan interest model, 12/78’s of the finance charge is assessed as the first month’s portion of interest due, 11/78’s as the second month’s portion and so on.

When an Add On loan is paid off before maturity, a rebate of the unearned finance charge is given. A simplified example of how the rebate is calculated could be if we use $78 as the total finance charge for a 12 month loan. This represents the sum of digits by adding 12,11,10,9,8,7,6,5,4,3,2 & 1 which equals 78. If the loan is paid off in 3 months, the lender would rebate the sum of digits remaining or 9, 8,7,6,5,4,3,2 & 1 or $45. The lender retains the first three digits 12,11 & 10 or $33. The borrower would not receive as much of a rebate as if it were divided equally by 12 months ($6.50 per month). In that scenario the rebate would be $58.50 opposed to $45.

There are several states that prohibit the Rule of 78’s formula in car loans of 5 years or less. Check with your state Auto Dealer’s Association for details. Also verify that the Dealer Management Software solution you’re utilizing provides the choice of interest calculation methods.