- Loan interest basics
- What is the Rule of 78?
- How Rule of 78 loan interest is calculated
- Rule of 78 vs. simple interest
- When you may encounter the Rule of 78
Loan interest basics
When you repay financing, some of your monthly payments goes toward repaying the principal (the number you borrowed) along with a portion toward interest (the lender's fee around the money you borrowed).
Lenders can use the straightforward interest method for calculating your charges. With this particular method, your loan balance starts off with just the principal you borrowed. Interest is calculated according to your loan balance between payment dates. If you repay your loan before the end of the loan term, you'll pay less in interest.
Or, lenders can follow the Rule of 78, which depends on calculating interest in advance. If your loan interest is calculated beforehand, your balance includes both principal you borrowed and all the interest you will be likely to pay over the lifetime of the borrowed funds – assuming you repay it based on the loan terms. Interest charges are calculated according to a preset schedule, and not according to that which you actually owe as you repay the borrowed funds.
What may be the Rule of 78?
The Rule of 78 is a method of calculating how much precalculated interest a lender refunds to some borrower who takes care of a loan early. This calculation method almost always works in the lender's favor, letting them keep more money in their pockets when refunding loan interest.
The Rule of 78 is designed to ensure that borrowers spend the money for same interest fees over the lifetime of financing as they would having a loan that uses the simple interest method. But due to some mathematical quirks, you end up paying a larger share from the interest upfront. Which means if you remove the loan early, you'll wind up paying more overall for a Rule of 78 loan compared with a simple-interest loan.
Origins from the Rule of 78
The Rule of 78 dates towards the Great Depression era, when people generally got small loans with low interest and short terms. Just like today, sometimes people paid off their loans early and didn't expect to pay the entire amount of interest charges. Lenders, on the other hand, wanted borrowers to pay the entire amount of precalculated interest.
In 1935, the Indiana state legislature ruled that people who pay off their loans early don't need to pay the full interest. The formula contained in this law was the Rule of 78.
How Rule of 78 loan interest is calculated
So how can Rule of 78 calculations work?
First, you set up all the digits for the number of months within the loan. For a 12-month loan, that number is 78 (1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78). Next, you reverse the order from the number of months. So, the very first month from the loan could be assigned the number 12 (for the last month of the year), then your second month would be assigned the number 11 (for that 11th month of the year), and so on.
Then, you divide that assigned number (which may be 12 for the first month of the loan, for example) by 78 to calculate what number of the total interest you'd pay in that month. Finally, to calculate what that monthly interest charge is, you multiply that percentage by the total interest charge over the lifetime of the borrowed funds to see how much interest pays for the reason that month alone.
Here's a good example using a loan with a $500 interest charge over the lifetime of the borrowed funds.
| Month | Numerator | Denominator | Percentage of total interest | Monthly interest |
|---|---|---|---|---|
| 1 | 12 | 78 | 15.4% | $77.00 |
| 2 | 11 | 78 | 14.1% | $70.50 |
| 3 | 10 | 78 | 12.8% | $64.00 |
| 4 | 9 | 78 | 11.5% | $57.50 |
| 5 | 8 | 78 | 10.3% | $51.50 |
| 6 | 7 | 78 | 9.0% | $45.00 |
| 7 | 6 | 78 | 7.7% | $38.50 |
| 8 | 5 | 78 | 6.4% | $32.00 |
| 9 | 4 | 78 | 5.1% | $25.50 |
| 10 | 3 | 78 | 3.8% | $19.00 |
| 11 | 2 | 78 | 2.6% | $13.00 |
| 12 | 1 | 78 | 1.3% | $6.50 |
| Total | 100.0% | $500.00 |
Rule of 78 vs. simple interest
When you have to pay off financing early, federal law needs a lender to refund to you any unearned part of interest that you simply paid.
If a lender uses the Rule of 78 to calculate how much to refund you, they are able to actually keep more of your prepaid interest than when they used the greater common simple interest method of calculation.
Here's an example.
Let's say you have to remove a 12-month loan in January for $6,000 to cover home repairs. If the rate of interest with that loan is 5%, you'll have to pay almost $164 in interest over the course of the year, regardless of whether the lender uses the Rule of 78 method or even the simple interest method.
| Monthly interest payment | |||
| Month | Rule of 78 method | Simple interest method | Difference |
| January | $25.18 | $25.00 | $0.18 |
| February | $23.08 | $22.96 | $0.12 |
| March | $20.98 | $20.92 | $0.06 |
| April | $18.89 | $18.87 | $0.02 |
| May | $16.79 | $16.80 | -$0.01 |
| June | $14.69 | $14.73 | -$0.04 |
| July | $12.59 | $12.66 | -$0.07 |
| August | $10.49 | $10.57 | -$0.08 |
| September | $8.39 | $8.47 | -$0.08 |
| October | $6.30 | $6.37 | -$0.07 |
| November | $4.20 | $4.25 | -$0.05 |
| December | $2.10 | $2.13 | -$0.03 |
You can easily see from this example that while the difference isn't huge, the earlier interest payments calculated while using Rule of 78 loan are greater than those calculated while using simple interest loan. Should you repay the loan in March, for example, you will have paid 36 cents more ($0.18 + $0.12 + $0.06 = $0.36) towards the lender using the Rule of 78 loan in comparison to the simple interest loan.
For probably the most part, these differences are small. However the longer the borrowed funds term extends and also the higher the eye rate, the higher the difference you will see between the two methods.
When you may encounter the Rule of 78
Although the Rule of 78 allows lenders to help keep more prepaid interest – even when a borrower takes care of a loan early – they cannot make use of this on impulse. You will find rules governing when a lender can apply the Rule of 78.
Federal law generally stipulates that in some instances – like mortgage refinances and other types of consumer loans with precalculated interest – lenders can't use the Rule of 78 to loans with repayment periods of longer than 61 months.
Some states prohibit utilisation of the Rule of 78, while some allow lenders to apply it to loans shorter than 61 months.
Bottom line
If your loan is for longer than 61 months – or shorter, but you don't intend to pay it off early – you might not need to worry about the Rule of 78.
But if your loan is perfect for a shorter term (personal loans could be) or you plan to pay it back early, it's important to know how your interest is calculated – using either the straightforward interest or precalculated method. If your loan has precalculated interest and also you pay it off early, you can wind up getting a smaller amount of your prepaid interest refunded.
With any loan product, it's important to do your homework prior to signing on the dotted line. Be sure you're using a reputable lender and you understand all the loans, including what happens should you remove the loan early.
