When it comes to car loans and refinancing, understanding terminologies can save you from
disadvantageous deals, possible scams, and unexpected debt. Especially in Singapore where
most people would need to apply for a car loan in order to afford a car, being knowledgeable
about the different payment schemes and jargon allows you to strategize your finances better so
you can get a ride that best suits your lifestyle.
For people looking to sell their cars after a couple of years or for those who try to avoid debt,
paying off car loans ASAP sounds like a good plan. However, if you finance your loan using the
Rule of 7(8), paying too early may not be a financially wise decision.
What is Rule of 7(8)?
Essentially, the Rule of 7(8) refers to a payment scheme that tapers off the payment for your
interest. That means that even if you have a set interest rate for the full term of your car loan,
you pay more interest in the first few months until you’re paying less of it and more of the
principal. The Rule of 7(8) pertains to the sum of the number of months in a one-year loan — as
in 12 + 11 + 10 + 9 + 8 + 7 + 6+ 5 + 4 + 3 + 2 + 1 = 7(8) — although the name also applies to
loans with longer loan periods.
For the most part, the Rule of 7(8) is advantageous if you’re planning to keep to your loan
period; after all, the payments become lighter as time passes. However, if you’re planning on
selling your car before the loan period ends or if you managed to land a windfall and want to
erase your debt as soon as possible, the Rule of 7(8) can actually work against you: paying your
loan too early means that you’re paying more interest, and you can only rebate up to 80% of the
interest upon full payment.
Computing For The Rule of 7(8)
The Rule of 7(8) is actually an old practice of pre-calculating the loan interest, assuring the
lender that they have the advantage in the transaction. For banks lending with the Rule of 7(8),
this method allows them to be compensated for lending even if the loaner pays their debt early
and terminates the bank’s projected income stream. It’s also likely that they will impose an early
settlement penalty and other administrative fees, so best make sure that the loan period you’re
applying for is the one that works best for you even if it comes with a heftier principal.
For example, the bank granted you a $100,000 car loan with a 5% interest rate payable in 60
months under the Rule of 7(8).Technically, you’re still paying the $1,750 monthly fee, but the
shares between the principal and interest are different. In the first year of your car loan, your
payment scheme looks more like this:
The Interest in this case is computed by subtracting the interest balance from the total amount
of interest. To find the interest balance, Rule of 7(8) uses this formula:
This means that to find out how much more you need to pay for your interest (R), you need to
multiply the number of months remaining in your loan (n) with that number plus one, then divide
it by the original number of months of your loan (N) multiplied by that original loan period plus
one. Then you multiply that quotient by the total amount of the interest that you need to pay for
the whole period (TC).
Why Paying Too Early Is A Disadvantage
Let’s say that after the first year of paying off your car loan, you want to sell your car for another
model, but you need to pay off the loan balance first. In order to find out how much you need to
pay the bank, you need to compute the Loan Redemption Amount, which is your initial loan
amount + total interest - installments paid - 80% of unpaid interest (R).
In our example, that would be $100,000 + $5,000 - ($1,750 x 12 months already paid) - 80% of
$3,213.11, the unpaid interest computed through the formula above. After already paying
$21,000 for a year, you still need to pay back $81,429.51, which means that you’re paying
almost half of the total interest even if you only borrowed for less than a quarter of your loan
period. Considering that it’s unlikely that you can sell your car at the full price you bought it at,
you’d just be spending money at a loss.
Car deals can be confusing but it’s not impossible to find one that suits your financial situation,
lifestyle and preferences. The trick is to find a car dealership that has your interests at heart,
with a comprehensive service that makes sure that you’re driving away with the car of your
CarVault specializes in a full-service car dealership, from securing your COE to finding
you the best financing options. Drop us a call or WhatsApp at 8883 2909 to speak with our
experts or book a no-obligations appointment with us today!