What is Rule of 78 and how can it impact lending?

Some lenders use a tricky strategy known as the Rule of 78 to ensure you pay more for your loan up front, thanks to pre-calculated interest charges. While this practice is prohibited in some states, other states allow loans with terms longer than 61 months. If a lender applies the rule of 78, paying off your loan early could cost you more than expected.

What is the Rule of 78?

When the Rule of 78 is implemented, you pay interest in a way that ensures the lender gets its share of the profit, even if a loan is paid off early. It is a method of calculating and applying interest to a loan in which a greater portion of the interest expense is allocated to the previous repayments of the loan.

Although it was banned in 1992 for loans with terms longer than 61 months, some lenders still use this practice. It is widely seen as unfair to borrowers who decide to pay off their loans early to save money on interest.

How the Rule of 78 works against borrowers

The interest rate structure of the Rule of 78 is intended to favor the lender over the borrower.

“If a borrower pays the exact amount due each month over the life of the loan, the Rule of 78 has no effect on the total interest paid,” says Andy Dull, vice president of credit underwriting at Freedom Financial Asset Management. auxiliary company.

“However, if a borrower considers the option of paying off the loan early, it really makes a difference. Under the terms of the Rule of 78, the borrower will pay a much larger portion of the interest earlier in the loan period.”

In other words, you save less by making additional payments ahead of schedule than if the lender charged simple interest.

The Rule of 78 formula

Please note that for a 12 month loan the rule of 78 applies, but for a 24 month loan the rule of 300 applies as the numbers added together would lead to that amount. Loans with terms of 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 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 result is that you pay more interest than necessary.

Additionally, the Rule of 78 ensures that any additional payments you make are treated as prepayment of principal and interest due in subsequent months.

How the Rule of 78 Affects Loan Interest Rates

Under the rule of 78, a lender weighs interest payments in reverse order, with more weight given to the early months of the loan’s repayment period. According to this rule, this is the amount you would pay in interest each month if you took out a twelve-month loan with a total interest charge of € 2,000.

As you can see, early payments with the Rule of 78 are more interest-bearing.

Rule of 78 versus simple interest

While the rule of 78 can be used for some types of loans (usually subprime auto loans), there is a much better (and more general) method that lenders can use when calculating interest: the simple interest method.

With simple interest, your payment is first applied to the month’s interest, while the remainder of the monthly payment reduces the principal amount. Simple interest is only calculated on the principal amount of your borrowed amount, so you never pay interest on the accrued interest.

Unlike 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 decrease as you pay off your loan because your principal balance will decrease, but you will always use the same number to calculate your monthly interest payment.

Under the Rule of 78, a $5,000 personal loan with an interest rate of 11 percent over 48 months and a payment of $150 per month would incur an interest charge of $89.80 in the first month. If the lender uses the simple interest method, your interest costs in the first month will be €45.83 – almost 50 percent less.

How do you know if a lender is using the rule of 78?

During the financing process, your lender may not always indicate whether your loan agreement applies the Rule of 78 to the interest calculation. That’s why it’s so important to read your loan agreement carefully.

Look for mentions of the Rule of 78 or pre-calculated interest in your agreement.

If an interest refund is mentioned, it may be a signal for you to ask deeper questions about how your lender calculates the interest on your loan. Some lenders that apply Rule 78 to your loan include fine print about how they will handle an interest rate discount or refund in the event you decide to pay off the loan in full before the full repayment period expires.

If there is no specific Rule of 78 language in your agreement, the clearest way to know if the lender uses this interest rate method is to ask.

it comes down to

Fortunately, the Rule of 78 has largely disappeared, even in cases where its use would still be legal. You probably don’t need to worry about it unless you’re a subprime borrower looking for an auto loan or personal loan with a term of 60 months or less.

But lenders who still use the rule of 78 want to make as much money financing your loan as is legally possible – this can be especially true if you get a low interest rate. Even if you don’t plan to pay off your loan early, it’s always a good idea to understand how the interest on your loan is calculated if you change your repayment strategy.