There are several ways that the interest portion of a payment can be calculated on a loan. LoanPro currently gives four options for calculating the interest portion of a payment: Interest Only, Rule 78, Simple Interest, and Simple Interest Locked. This article will cover each of these options in detail.
For additional information on how loan calculations work, see Typical Loan Overview.
For an interest-only loan payment, the payment amount is set equal to the amount of interest that comes due in a single loan period. This means that the principal amount on the loan is not re-paid, so the same amount of interest comes due in each payment period.
The rule of 78s is an alternative method for calculating the interest portion of a loan payment.
First, it is necessary to calculate the total finance charge for the loan. In most cases, this is done by subtracting the total loan amount from the total of payments.
Then, the loan period numbers are totaled. For example, if you have a 12 month loan, you would total the loan period numbers 12 + 11 + 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 78. This is where the rule of 78s gets its name. If the loan had three periods, the total would be 3 + 2 + 1 = 6.
Next, interest for a payment period is calculated by dividing the number of the payment period in reverse order by the total of the payment period numbers and multiplying this number by the finance charge. In our 12-month example, the interest in the first period is calculated as Total Finance Charge x (12 ÷ 78). The second period interest is calculated as Total Finance Charge x (11 ÷ 78) and so on. This is a less accurate way to calculate interest on a loan.
This is the most typical loan calculation type. Interest is calculated the same way it is in our typical loan example. That is, interest per payment period is calculated as the outstanding loan balance multiplied by the period interest rate.
Simple Interest Locked
The interest for simple interest locked is calculated in the same way as simple interest. The difference is that the interest amount is locked from the time the loan is originally calculated. This means that borrowers will be required to pay all the interest and no more. Extra interest will not accrue if borrowers are late on payments, and the borrowers won’t pay less interest if they pay their loans off early.