What is the Rule of 78?

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Whenever you borrow money, you should have a full understanding of the interest rate you’re paying, as well as how interest is calculated. That second part is important, because some lenders use a tricky strategy known as the Rule of 78 to ensure that you pay more for your loan thanks to pre-calculated interest charges.

When the Rule of 78 is in play, borrowers pay interest in a way that ensures that the lender gets its share of profit 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.

How the Rule of 78 affects loan interest

The Rule of 78 is a financing method that includes pre-calculated interest charges, ensuring that a lender gets its share of profit. The pre-calculated interest makes it harder (if not impossible) for borrowers to benefit from interest savings by paying off their loan early.

To use the Rule of 78 on a 12-month loan, a lender would add the number of 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 a rule of 300, since the sum of the numbers would add up to that amount. Loans that last 36 months, 48 months and so on would follow the same format.

With the figure calculated, 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 the borrower paying more interest than they should upfront. Further, the Rule of 78 makes it so that extra payments are treated as prepayment of the monthly payments and interest due in subsequent months.

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.

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 upfront. 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 on 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.

The bottom line

The Rule of 78 can easily thwart your plans if you plan to pay off an installment loan early, so you should make sure that you don’t pay interest using this method if you can avoid it. Fortunately, the Rule of 78 has largely gone out of fashion even in instances where using this method is legal, so 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.

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