What is the Rule of 78?

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

When the Rule of 78 is implemented, you pay interest in a way that ensures that the lender gets its share of profit even if a loan is paid off early. Fortunately, the Rule of 78 was outlawed nationally starting in 1992 for loans that last longer than 61 months. Many states have also outlawed use of the Rule of 78 completely. Here’s a closer look at 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 larger portion of the interest charges to the earlier loan repayments. It may still be used by some, but not many, lenders. It is widely viewed as unfair to borrowers who may decide to pay their loans off early to get out of debt.

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

Under the Rule of 78, a lender weights interest payments in reverse order, with more weight given to the earlier months of the loan’s repayment period.

Why is it important?

It’s critical to understand what type of financing will be applied to your loan’s repayment plan, particularly if you intend to pay the loan off ahead of time. The interest structure of the Rule of 78 favors the lender over the borrower in a few ways.

“If a borrower pays the exact amount due each month for the life 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 the possibility of paying off the loan early, it makes a real difference. Under the terms of the Rule of 78, the borrower will pay a much greater portion of the interest earlier in the loan period.”

In other words, under the Rule of 78, there is very little benefit or savings to be achieved by paying a loan in full well ahead of schedule.

How the Rule of 78 affects loan interest

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

To use the Rule of 78 on a 12-month loan, a lender would add the digits within the 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 comes with a Rule of 78, but that a 24-month loan would follow the Rule of 300, 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. For example, you would pay 12/78 of the interest in the first month of the loan, 11/78 of the interest in the second month and so on. The end result is that you pay more interest than you should up front.

“Typically, the Rule of 78 results in a borrower paying more of the yearly interest due in the first three or four months and less in the last three or four months,” Sullivan says.

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.

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 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.

Consider this example, which shows how your interest charges would look for a 12-month loan with $2,000 in interest charges if a lender used the Rule of 78 over 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
10 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 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. That’s not good news if you’re trying to get out of debt faster and save money along the way.

How is the Rule of 78 different from simple 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.

With simple interest, your payment is applied to the month’s interest first, 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 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 amount you pay in interest will still go down as you pay off your loan, since your principal balance will shrink, but you’ll always use the same number to calculate your monthly interest payment.

The bottom line

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. You likely don’t need to worry about it unless you’re a subprime borrower seeking an auto loan that lasts for 60 months or less.

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

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Written by
Holly D. Johnson
Author, Award-Winning Writer
Holly Johnson began her career working in the funeral industry, which may make you wonder why she works in personal finance now. Yet, the funeral industry taught the author everything she needs to know about the value of one's money and time. Johnson left the mortuary business a decade ago in order to explore her passion for personal finance and travel the world, and since then, she and her husband have built a debt-free lifestyle that has them on the path to retire very wealthy in their 40s. Holly's love of budgeting also led to the creation of her debt payoff book, “Zero Down Your Debt: Reclaim Your Income and Build a Life You’ll Love."
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