What is the rule of 78?


Some lenders use a tricky strategy known as the Rule of 78 to ensure that you pay more for your loan up front through pre-calculated interest charges.

When the rule of 78 is implemented, you pay interest so that the lender receives their share of the profits even if a loan is paid off early. Fortunately, the rule of 78 was banned nationally from 1992 for loans longer than 61 months. Many states have also banned the use of the Rule of 78 completely. Here is an overview of what the Rule of 78 is and how it works.

What is the rule of 78?

The Rule of 78 is a method of calculating and applying interest on a loan that allocates a greater portion of the interest expense to past loan payments. It can still be used by some lenders, but not by many. It is widely viewed as unfair to borrowers who may decide to pay off their loans early to get out of debt.

Borrowers pay more with the Rule of 78 than just interest, says Michael Sullivan, personal financial consultant at Take Charge America, a nonprofit credit counseling and debt management agency. Since many loans were for 12 months in the past, he says, the formula is based on interest from months one through 12, which adds up to 78.

Under the Rule of 78, a lender weights interest payments in reverse order, giving more weight to the first few months of the loan repayment period.

Why is this important?

Understanding what type of financing will be applied to your loan repayment plan is critical, especially if you intend to repay the loan in advance. The Rule of 78 interest structure favors the lender over the borrower in several ways.

“If a borrower pays the exact amount owed each month during the term of the loan, the rule of 78 will have no effect on the total interest paid,” says Andy Dull, vice president of credit underwriting for Freedom Financial Asset Management, a debt relief company. “However, if a borrower is considering paying off the loan early, it makes a real difference. Under the Rule of 78, the borrower will pay a much larger portion of the interest earlier in the loan period. “

In other words, according to the Rule of 78, there are very few benefits or savings to be made by paying off a loan in full well before maturity.

How the Rule of 78 Affects Interest on Loans

The pre-calculated interest charges applied under the Rule of 78 ensure that a lender gets their share of the profits. They also make it more difficult (if not impossible) for borrowers to benefit from the interest savings that might otherwise be achieved by paying off a loan early.

To use the rule of 78 on a 12 month loan, a lender would add the numbers within 12 months using the following calculation:

  • 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78

Note that a 12 month loan has a rule of 78, but a 24 month loan would follow the rule of 300 because the numbers would match that amount. Loans that last 36 months, 48 ​​months and so on would follow the same format.

The lender allocates a fraction of the interest for each month in reverse order. For example, you would pay 12/78 interest in the first month of the loan, 11/78 interest in the second month, and so on. The end result is that you pay more interest than you should initially.

“Typically, the rule of 78 results in a borrower paying more than the annual interest owed in the first three or four months and less in the last three or four months,” Sullivan says.

Additionally, the Rule of 78 ensures that any additional payment you make is treated as a prepayment of principal and interest due in subsequent months.

Calculating interest with the rule of 78

Imagine you are in the unfortunate position of having a loan that uses the rule of 78. In this case, you would be required to pay a pre-calculated percentage of your total interest, regardless of the actual principal balance that you have. rest.

Consider this example, which shows what your interest charges would look like for a 12-month loan with $ 2,000 in interest charges if a lender used the rule of 78 during the life of the loan.

Month of loan repayment Portion of interest charged Monthly interest charges
1 12/78 $ 308
2 11/78 $ 282
3 10/78 $ 256
4 9/78 $ 230
5 8/78 $ 206
6 7/78 $ 180
7 6/78 $ 154
8 5/78 $ 128
9 4/78 $ 102
ten 3/78 $ 76
11 2/78 $ 52
12 1/78 $ 26

As you can see, the rule of 78 packs the loan with more interest up front. If you pay your loan on the original repayment schedule, the rule of 78 and the simple interest method would cost the same total amount. However, if you try to pay off your loan sooner by making additional payments, under the Rule of 78, that additional money will count towards future payments and interest. It’s not good news if you’re trying to get out of debt faster and save money along the way.

How does the rule of 78 differ from simple interest?

While the Rule of 78 can be used for certain types of loans (typically for subprime auto loans), there is a much better (and more common) method that lenders use to calculate interest: the simple interest method.

With simple interest, your payment is first applied to the interest for the month, with the remainder of the monthly payment reducing the principal balance. Simple interest is calculated on the principal of your loan amount only, so you never pay interest on accrued interest.

Unlike the rule of 78, where the portion of interest you pay decreases each month, simple interest uses the same daily interest rate to calculate your interest payment each month. The amount you pay in interest will always decrease as you pay off your loan because your principal balance will decrease, but you will still use the same number to calculate your monthly interest payment.

The bottom line

The Rule of 78 can easily thwart your plans to prepay an installment loan, so avoid loans that use this method if you can. Fortunately, the Rule of 78 is largely outdated, even in cases where its use would still be legal. You probably don’t have to worry about this unless you are a subprime borrower looking for a car loan with a term of 60 months or less.

“Since the federal government and many state governments have banned the use of Rule 78, it should above all be seen as a useful reminder to consumers that they cannot simply assume that loan terms and conditions repayment schedules are correct and fair, ”says Sullivan. “There are always ways to bend things in favor of a lender. But even if the Rule of 78 were applied, it would only be important for a borrower who wanted to repay a loan early. “

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