Steer clear of the
perilous 'Rule of 78s'
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
of 78s is a historical anachronism," says David Rubinstein, vice president
of the Virginia Citizens Consumer Council. "It's simply another way of padding
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.
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.
For a borrower looking to end an auto loan early, there isn't a
worse way a lender could calculate your payoff amount. The Rule of 78s formula
packs extra interest charges into the early months of a loan. Using Rule of 78s,
a lender typically collects three-quarters of a loan's interest in the first half
of a loan term.
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
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
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.
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.
Interest padding ahead
Let's say you're ready to pay off your 48-month
auto loan a year early. Because you signed on for a pre-computed loan, you're
on the hook for 48 months worth of interest even though you're paying off the
loan in 36 months.
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.
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."
on the warning lights
In 1992, the U.S. Congress outlawed the use of
the "Rule of 78s" formula in closed-end loans longer than 61 months.
just gets very egregious with a longer-term loan," says Elizabeth Renuart,
staff attorney at the National Consumer Law Center.
| States outlawing
use of the Rule of 78s formula in installment loans of five years and less: |
CARLAW, a monthly legal reporting service for legal compliance specialists in
the automobile industry.|
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.
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.
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."
out for 'interest rebates'
Don't let this happen to you. Be leery of
signing any financing contract that mentions a refund or rebate of interest. That's
a sure sign you're about to sign on for a pre-computed loan and not a simple interest
loan. Be sure to ask.
"If you see that there may be a
refund of interest, that's the first red flag that you don't want this loan,"
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.
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.
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."