What Is the Rule of 78?
The Rule of 78 is a method used by some lenders to calculate interest charges on a loan. The Rule of 78 requires the borrower to pay a greater portion of interest in the earlier part of a loan cycle, which decreases the potential savings for the borrower in paying off their loan.
Key Takeaways
- The Rule of 78 is a method used by some lenders to calculate interest charges on a loan.
- The Rule of 78 allocates pre-calculated interest charges that favor the lender over the borrower for short-term loans or if a loan is paid off early.
- The Rule of 78 methodology gives added weight to months in the earlier cycle of a loan, so a greater portion of interest is paid earlier.
Understanding the Rule of 78
The Rule of 78 gives greater weight to months in the earlier part of a borrower’s loan cycle when calculating interest, which increases the profit for the lender. This type of interest calculation schedule is primarily used on fixed-rate non-revolving loans. The Rule of 78 is an important consideration for borrowers who potentially intend to pay off their loans early.
The Rule of 78 holds that the borrower must pay a greater portion of the interest rate in the earlier part of the loan cycle, which means the borrower will pay more than they would with a regular loan.
Calculating Rule of 78 Loan Interest
The Rule of 78 loan interest methodology is more complex than a simple annual percentage rate (APR) loan. In both types of loans, however, the borrower will pay the same amount of interest on the loan if they make payments for the full loan cycle with no pre-payment.
The Rule of 78 methodology gives added weight to months in the earlier cycle of a loan. It is often used by short-term installment lenders who provide loans to subprime borrowers.
In the case of a 12-month loan, a lender would sum the number of digits through 12 months in the following calculation:
- 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78
For a one year loan, the total number of digits is equal to 78, which explains the term the Rule of 78. For a two year loan, the total sum of the digits would be 300.
With the sum of the months calculated, the lender then weights the interest payments in reverse order applying greater weight to the earlier months. For a one-year loan, the weighting factor would be 12/78 of the total interest in the first month, 11/78 in the second month, 10/78 in the third month, etc. For a two-year loan, the weighting factor would be 24/300 in the first month, 23/300 in the second month, 22/300 in the third month, etc.
Rule of 78 vs. Simple Interest
When paying off a loan, the repayments are composed of two parts: the principal and the interest charged. The Rule of 78 weights the earlier payments with more interest than the later payments. If the loan is not terminated or prepaid early, the total interest paid between simple interest and the Rule of 78 will be equal.
However, because the Rule of 78 weights the earlier payments with more interest than a simple interest method, paying off a loan early will result in the borrower paying slightly more interest overall.
In 1992, the legislation made this type of financing illegal for loans in the United States with a duration of greater than 61 months. Certain states have adopted more stringent restrictions for loans less than 61 months in duration, while some states have outlawed the practice completely for any loan duration. Check with your state's Attorney General's office prior to entering into a loan agreement with a Rule of 78 provision if you are unsure.
The difference in savings from early prepayment on a Rule of 78 loan versus a simple interest loan is not significantly substantial in the case of shorter-term loans. For example, a borrower with a two-year $10,000 loan at a 5% fixed rate would pay total interest of $529.13 over the entire loan cycle for both a Rule of 78 and a simple interest loan.
In the first month of the Rule of 78 loan, the borrower would pay $42.33. In the first month of a simple interest loan, the interest is calculated as a percent of the outstanding principal, and the borrower would pay $41.67. A borrower who would like to pay the loan off after 12 months would be required to pay $5,124.71 for the simple interest loan and $5,126.98 for the Rule of 78 loan.
FAQs
The Rule of 78 formula
What is the Rule of 78 loan calculation? ›
Calculating Rule of 78 Loan Interest
It is often used by short-term installment lenders who provide loans to subprime borrowers. In the case of a 12-month loan, a lender would sum the number of digits through 12 months in the following calculation: 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78.
How is the Rule of 78 rebate calculated? ›
The Rule of 78s is also known as the sum of the digits. In fact, the 78 is a sum of the digits of the months in a year: 1 plus 2 plus 3 plus 4, etc., to 12, equals 78. Under the rule, each month in the contract is assigned a value which is exactly the reverse of its occurrence in the contract.
What is the Rule of 78 dictates that a borrower pays? ›
The Rule of 78 is designed so 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. But because of some mathematical quirks, they end up paying a greater share of the interest upfront.
How to use the Rule of 78? ›
For example, the formula for a 12-month loan would be 12 + 11 + 10 and so on. The sum is your denominator. Your weighted monthly interest payment is then calculated in reverse order, meaning the first month's payment would be 12/78 of the total interest, the second month's payment would be 11/78 and so on.
What does 78 loan to value mean? ›
Your LTV determines whether you'll pay private mortgage insurance (PMI) on a conventional loan. An LTV of 80% or more usually requires PMI. You may request that your PMI be canceled once you reach 80% LTV, or it will be automatically canceled once you reach 78% LTV.
What are the alternatives to the Rule of 78? ›
Amortization Schedule: An alternative to the Rule of 78 is an amortization schedule, which follows a more favorable path for borrowers aiming to reduce their principal. With an amortization schedule, each payment is divided between interest and principal, with the proportion of interest decreasing over time.
What is the Rule of 78 vs actuarial method? ›
The Rule of 78 accelerates the accrual of interest at the start of the loan, and the purpose of using the actuarial method for posting to income is to avoid having that acceleration reflected in the ledger.
What is the Rule of 78 revenue? ›
Rule of 78 formula
Just multiply the amount of new revenue you expect to bring in each month by 78 to get your yearly sales forecast. A caveat to the Rule of 78 formula is that it assumes you'll gain just one new customer per month – and that every customer is paying the same monthly fee.
What is the Rule of 78 refund? ›
The Rule of 78s is commonly – even widely -- used but is understood by very few people. It is a method of refunding on consumer transactions where the borrower prepays the account. It is not the only refunding method that is available under the law. The Rule of 78s is also known as the sum of the digits.
The rule of 78 is a method for apportioning the total gross income from a precomputed finance charge, or from a credit life premium, to each installment period, in a way that recognizes the declining nature of the indebtedness.
How is a simple interest loan different from the Rule of 78? ›
Simple interest is only calculated on the principal of your loan amount, so you never pay interest on the accumulated interest. Unlike the Rule of 78, where the portion of the interest you pay decreases each month, simple interest uses the same daily interest rate to calculate your interest payment each month.
What is Rule of 78 effective interest rate? ›
The Rule of 78 formula is: Effective interest Rate = total Interest Paid / Principal Amount. 7. Interpret the Result: The effective interest rate represents the annualized cost of borrowing under the specific terms of the loan. This percentage is what you are truly paying for the privilege of borrowing money.
What is the Fed Rule 78? ›
(a) Providing a Regular Schedule for Oral Hearings. A court may establish regular times and places for oral hearings on motions. (b) Providing for Submission on Briefs. By rule or order, the court may provide for submitting and determining motions on briefs, without oral hearings.
How to get out of a precomputed loan? ›
You can pay off the loan early if you want, but you won't get much benefit from doing so. Refinancing isn't going to help you either because your new lender will consider the precomputed interest part of your new balance, so you'll still have to pay it.
Does the Rule of 72 really work? ›
The Rule of 72 applies to compounded interest rates and is reasonably accurate for interest rates that fall in the range of 6% and 10%. The Rule of 72 can be applied to anything that increases exponentially, such as GDP or inflation; it can also indicate the long-term effect of annual fees on an investment's growth.
How do you calculate 75% loan to value? ›
If you make a $10,000 down payment, your loan is for $80,000, which results in an LTV ratio of 80% (i.e., 80,000/100,000). If you were to increase the amount of your down payment to $15,000, your mortgage loan is now $75,000. This would make your LTV ratio 75% (i.e., 75,000/100,000).
What is the Rule of 78 in Excel? ›
Rule of 78 formula
Just multiply the amount of new revenue you expect to bring in each month by 78 to get your yearly sales forecast. A caveat to the Rule of 78 formula is that it assumes you'll gain just one new customer per month – and that every customer is paying the same monthly fee.
