There a 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, Simple Interest Locked. This article will cover each of these options in detail.
For additional background 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 78’s is an alternative method for calculating the interest portion of a loan payment. First it is necessary to calculate the finance charge for the loan. This is done by subtracting the total loan amount from the total of payments in most cases. The loan period numbers are then 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 78’s gets it’s name. If the loan had three periods, the total would be 3 + 2 + 1 = 6.
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. 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 as 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. That means that the borrower will be required to pay all the interest and no more. Extra interest will not accrue if the borrower is late on their payments, and the borrower won’t pay less interest if they pay the loan off early.