What is the Rule of 78
The Rule of 78 is a method used by some lenders for calculating interest charges on a loan. Rule of 78 loans require the borrower to pay a greater portion of interest in the earlier part of a loan cycle which decreases the potential savings for a borrower in paying off their loan.
BREAKING DOWN Rule of 78
The Rule of 78 gives greater weight to months in the earlier part of a borrower’s loan cycle when calculating interest creating greater profits for the lender. This type of interest calculation schedule is primarily used on fixed rate non-revolving loans. It can be an important consideration for borrowers who potentially intend to payoff their loan early. In 1992 legislation made this type of financing illegal for loans in the U.S. with a duration of greater than 61 months.
Calculating Rule of 78 Loan Interest
The Rule of 78 loan interest methodology is much more complex than a simple annual percentage rate (APR) loan. In both types of loans however the borrower will pay the same amount of interest on the loan if they make payments for the full loan cycle with no pre-payment.
The Rule of 78 methodology gives added weight to months in the earlier cycle of a loan. It is often used by short-term installment lenders providing loans to subprime borrowers.
In a 12-month loan a lender would sum the number of digits through 12 months in the following calculation:
For a one year loan the total number of digits is equal to 78 which is how the Rule of 78 got its name. For a two year loan the total sum of the digits would be 300.
Once the sum of the months is calculated the lender then weights the interest payments in reverse order applying greater weight to the earlier months. For a one year loan the weighting factor would be 12/78 of the total interest in the first month, 11/78 in the second month, 10/78 in the third month, etc. For a two year loan the weighting factor would be 24/300 in the first month, 23/300 in the second month, 22/300 in the third month, etc.
Rule of 78 versus Simple Interest
When paying off a loan, the repayments consist of two parts: the principal and the interest charge. The Rule of 78 weights earlier payments with more interest than later ones. If the loan is not terminated or prepaid early, the total interest paid between simple interest and the Rule of 78 will be equal. However, because the Rule of 78 weights the earlier payments with more interest than a simple interest method, paying off a loan early will result in the borrower paying slightly more interest overall.
The difference in savings from early prepayment on a Rule of 78 loan versus a simple interest loan is not significantly substantial in the case of shorter term loans. For example a borrower with a two-year $10,000 loan at a 5% fixed rate would pay total interest of $529.13 over the entire loan cycle for both a Rule of 78 and simple interest loan. In the first month of the Rule of 78 loan the borrower would pay $42.33. In the first month of a simple interest loan the interest is calculated as a percent of the outstanding principal and the borrower would pay $41.67. A borrower who would like to pay the loan off after twelve months would be required to pay $5,124.71 for the simple interest loan and $5,126.98 for the Rule of 78 loan.