The Rule of 78 is a method that some lenders use to calculate the interest charges on a loan. It's a precomputed interest method that allocates a larger portion of the interest to the earlier months of a loan. This means that if you pay off the loan early, you may not get back as much of the interest you paid as you might expect.
Here's how it works:
- The lender adds up the months of the loan term (e.g., a 12-month loan has 12 months).
- Then, they add up the numbers from 1 to the number of months in the loan term (e.g., 1 + 2 + 3 + ... + 12 = 78). This is where the name "Rule of 78" comes from.
- The lender assigns a fraction to each month, with the first month getting the largest fraction and the last month getting the smallest.
- The fractions represent the portion of the total interest that is allocated to each month.
For example:
- In a 12-month loan, the first month would have a fraction of 12/78, the second month 11/78, and so on, with the last month having a fraction of 1/78.
Why the Rule of 78?
The Rule of 78 was designed to make the interest charges on a loan consistent with the declining balance method of interest calculation. This means that borrowers pay the same interest charges over the life of a loan as they would with a loan that uses the simple interest method.
However, the Rule of 78 can be disadvantageous to borrowers who pay off their loan early because they are not refunded all of the unearned interest.
Here's an example:
- Imagine a loan with a $1,000 principal amount, a 12-month term, and a 10% annual interest rate.
- If you pay off the loan after 3 months, you would have paid roughly 3/78 (or about 38%) of the total interest.
- You would only be refunded a small amount of the unearned interest, even though you had made several payments.
The Rule of 78 is often used for:
- Auto loans
- Personal loans
- Mortgages
However, the use of the Rule of 78 is becoming less common as more lenders adopt simple interest methods for calculating interest charges.
If you are considering a loan that uses the Rule of 78, be sure to understand the implications of this method and how it may affect your overall costs.
