Rule of 78 — Watch out for this auto loan trick
This is one rebate auto shoppers should avoid.
Some auto lenders still use the archaic and costly “Rule of 78s” formula to calculate a rebate of finance charges when a customer pays off a loan early. This rebate is actually a sneaky prepayment penalty.
“The Rule of 78s is a historical anachronism,” says David Rubinstein, vice president of the Virginia Citizens Consumer Council. “It’s simply another way of padding a loan.”
The Rule of 78s is a mathematical formula that was devised in the days before modern calculators. The formula was a quick way for lenders in the 1920s and 1930s to estimate payoff amounts when a customer paid ahead on an installment loan. It’s still around today.
Also known as the sum-of-the-digits method, the Rule of 78s gets its name from the sum of the digits one through 12 — the number of months in a year.
There are two basic types of auto loans: simple interest loans and pre-computed loans. The Rule of 78s can only be applied to pre-computed loans that are paid ahead of schedule. To understand why this is such a lousy deal for consumers, you have to understand how a pre-computed loan works.
With a pre-computed loan, the interest owed over the life of the loan is calculated using a standard amortization table. Once you sign on the dotted line for this type of loan, you’re obligated to pay back principal plus the full amount of interest that will accrue over the entire term of the loan.
To sum up, interest on a pre-computed loan is calculated in advance and you’re on the hook for every penny of it when you sign.
In contrast, with a simple-interest loan you’re charged interest each day based on the balance you owe. So the quicker you pay down your balance the less interest you pay. A simple interest loan with no prepayment penalties rewards customers who pay ahead.
Pay ahead with a pre-computed loan that applies the “Rule of 78s” method to prepayments and you’ll be slammed with a penalty, disguised as a rebate.
Caution: Interest padding ahead
But your lender is going to do you a “favor.” You don’t have to pay 48 months worth of interest. Instead, he’s going to determine your payout amount including a “rebate” for those 12 months worth of finance charges you won’t have to pay.
But your payout amount won’t be what you deserve. The reason? Using the “Rule of 78s” method, your lender applies more of your previous payments toward interest and less of your previous payments toward principal.
Since less is applied toward principal, the amount you owe will be higher than expected. The earlier you try to pay off one of these loans the more you’ll have to pay. The higher the interest rate, the more that payoff amount is going to hurt.
“If it had overcharged the lender and undercharged the consumer, it would have disappeared decades ago,” says Jean Ann Fox, director of consumer protection for Consumer Federation of America.
“It’s a dirty little secret.”
Turning on the warning lights
“It just gets very egregious with a longer-term loan,” says Elizabeth Renuart, staff attorney at the National Consumer Law Center.
Whether a lender can apply the “Rule of 78s” method to installment loans of five years or less is a matter of state law. Currently, 17 states prohibit the practice.
Earlier last year, U.S. Rep. John LaFalce, D-N.Y., introduced a bill (H.R. 1054) that would eliminate the use of the Rule of 78s formula in credit transactions.
Fortunately for consumers, simple interest loans are now the norm in the auto financing business. The vast majority of auto lenders do not use pre-computed auto loans and they do not use the Rule of 78s method to calculate prepayments.
“The Rule of 78s as it applies to installment auto sales is a relic of the past,” says David Robertson, executive director of the Association of Finance and Insurance Professionals.
“In today’s mainstream market, that would be an absolute rarity.”
The pre-computed Rule of 78s auto loans that do exist today tend to be found in the subprime market. Folks with less-than-perfect credit should be on the lookout.
“Buy here, pay here” auto lots and lenders that specialize in offering loans to borrowers with badly damaged credit may offer these consumer-unfriendly loans.
“All the ones I’ve seen have had really high interest rates,” says Mark Eskeldson, an auto expert and author of CarInfo.com, a consumer information and advocacy Web site.
“If a car dealer is trying to put you into a rule of 78s loan it’s fairly safe to assume that the dealer has packed your interest rate — he’s inflated it.”
Watch out for ‘interest rebates’
“If you see that there may be a refund of interest, that’s the first red flag that you don’t want this loan,” Eskeldson says.
And because it puts the most bucks in his pocket, there’s a good chance that a lender offering a pre-computed loan will apply the Rule of 78s formula to all prepayments.
Check the front of a loan contract to see whether it allows a refund or rebate of interest. Flip over to the back of the contract and look under the section on prepayments for further details. Some contracts even mention Rule of 78s.
“You’re more likely to find it in subprime, but you can’t assume it wasn’t used in the contract you signed,” Fox says. “You have to look.”
Avoid signing on to loans that apply the Rule of 78s formula to prepayments. If you’ve already signed on the dotted line, you’re best bet is to make your payments as scheduled. Because of the penalties, there’s really no point in paying ahead.
“You’re stuck,” says Jack Gillis, author of The Car Book. “You have no leverage. They’re not going to let you out of the deal. If you refinance you just end up paying more.”
|— Updated: Jan. 1, 2002|