The Rule of 78 requires the borrower to pay a greater portion of interest in the earlier part of a loan cycle, which decreases the potential savings for the borrower in paying off their loan. This type of interest calculation schedule is primarily used on fixed-rate non-revolving loans. The Rule of 78 is an important consideration for borrowers who potentially intend to pay off their loans early.
The Rule of 78 holds that the borrower must pay a greater portion of the interest rate in the earlier part of the loan cycle, which means the borrower will pay more than they would with a regular loan. The Rule of 78 loan interest methodology is 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 who provide loans to subprime borrowers. In the case of a 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 explains the term the Rule of For a two year loan, the total sum of the digits would be With the sum of the months calculated, the lender then weights the interest payments in reverse order applying greater weight to the earlier months.
When paying off a loan, the repayments are composed of two parts: the principal and the interest charged. The Rule of 78 weights the earlier payments with more interest than the later payments. 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.
In , the legislation made this type of financing illegal for loans in the United States with a duration of greater than 61 months. Certain states have adopted more stringent restrictions for loans less than 61 months in duration, while some states have outlawed the practice completely for any loan duration. Check with your state's Attorney General's office prior to entering into a loan agreement with a Rule of 78 provision if you are unsure. 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.
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Federal law restricts the conditions under which a lender can use the Rule of 78 to calculate an interest refund, and some states prohibit its use altogether. Lenders can use the simple interest method for calculating your interest payments. With this method, your loan balance starts off with only the principal you borrowed. Interest is calculated based on your loan balance between payment dates.
Or, lenders can follow the Rule of 78, which relies on calculating interest in advance. Interest charges are calculated according to a preset schedule, and not according to what you actually owe as you repay the loan.
The Rule of 78 is a method of calculating how much precalculated interest a lender refunds to a borrower who pays off a loan early. To use the Rule of 78 on a month loan, a lender would add the digits within the 12 months using the following calculation:. Note that a month loan comes with a Rule of 78, but that a month loan would follow the Rule of , since the numbers would add up to 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. The end result is that you pay more interest than you should up front. Additionally, the Rule of 78 makes it so that any extra payments you make are treated as prepayment of the principal and interest due in subsequent months.
Imagine you are in the unfortunate position of having a loan that uses the Rule of In that case, you would be asked to pay a pre-calculated percentage of your total interest, not taking into account the actual principal balance you have remaining.
As you can see, the Rule of 78 packs the loan with more interest up front. If you pay your loan according to the initial repayment schedule, the Rule of 78 and the simple interest method would cost the same total amount. However, if you try to repay your loan early by making additional payments, under the Rule of 78, that extra money will be counted toward future payments and interest. While the Rule of 78 can be used for some types of loans usually for subprime auto loans , there is a much better and more common method for lenders to use when computing interest : the simple interest method.
Simple interest is calculated on the principal of your loan amount only, so you never pay interest on accumulated interest. Unlike with 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 Rule of 78 can easily thwart your plans to pay an installment loan off early, so avoid loans that use this method if you can.
Fortunately, the Rule of 78 has largely gone out of fashion even in instances where its use would still be legal. Remember, lenders that still use the Rule of 78 want to make as much money from financing your loan as legally possible.
How We Make Money. Holly D. Written by. Holly Johnson writes expert content on personal finance, credit cards, loyalty and insurance topics. In addition to writing for Bankrate and CreditCards. Edited By Aylea Wilkins.
Edited by. Aylea Wilkins. Aylea Wilkins is an editor specializing in personal and home equity loans. She has previously worked for Bankrate editing content about auto, home and life insurance.
She has been ….
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