What Is the Rule of 78?
Let me explain the Rule of 78 to you directly—it's a method for calculating loan interest that puts more of the interest payments at the beginning of the loan term, which helps lenders but can hurt you if you decide to pay off your loan early. You'll see this mostly with fixed-rate loans that don't revolve, like some installment loans. If you're thinking about early repayment, you need to know this rule because it cuts into any savings you might expect.
How the Rule of 78 Impacts Borrowers and Lenders
This rule weights the early months of your loan cycle more heavily when figuring interest, so lenders make more profit right away. It's something I recommend you consider if you might pay off early—lenders get the upper hand here. Remember, with the Rule of 78, you're paying more interest up front than you would with a standard loan setup.
Breaking Down Rule of 78 Loan Interest Calculations
The Rule of 78 is more involved than just using APR, but if you stick to the full term, the total interest matches up. It adds extra weight to those early months, and you'll find it used by lenders for short-term loans, often with subprime borrowers like you might be.
Take a 12-month loan as an example: the lender adds up the digits from 1 to 12, which totals 78—that's where the name comes from. For a two-year loan, it's 1 through 24, summing to 300.
Once they've got that sum, they assign more interest to the start: in a one-year loan, month one gets 12/78 of the interest, and it decreases from there. For two years, it starts at 24/300. That's how it front-loads everything.
Comparing Rule of 78 and Simple Interest Loans
Your loan payments always break down into principal and interest. With the Rule of 78, those early payments carry more interest weight than later ones. If you go the full term, the total interest is the same as with simple interest.
But if you pay off early, you're stuck paying more interest under Rule of 78 than with simple interest. Back in 1992, U.S. law made this illegal for loans over 61 months. Some states go further, restricting it for shorter loans or banning it outright. I suggest you check with your state's Attorney General before signing anything with this provision.
The savings difference from early prepayment isn't huge for short loans. For a two-year $10,000 loan at 5%, total interest is $529.13 either way. But in month one, you'd pay $42.33 with Rule of 78 versus $41.67 with simple interest. After 12 months, payoff would be $5,124.71 for simple and $5,126.98 for Rule of 78.
The Bottom Line
In summary, the Rule of 78 calculates interest to favor lenders by loading it early, which makes early payoffs costlier for you as a borrower. Lenders gain from the extra interest upfront, so be cautious if you plan to prepay. It's not a big deal for very short loans due to small differences from simple interest, but U.S. law bans it for terms over 61 months, and some states are even stricter. Before you agree to this, talk to a financial pro and review your state laws to stay informed.
Key Takeaways
- The Rule of 78 puts more interest in the early months, benefiting lenders over you.
- You pay more interest early, so early payoff savings are reduced.
- It's used for short-term fixed-rate loans, often with subprime borrowers.
- Illegal in the U.S. for loans over 61 months, with varying state rules.
- Early payoff means slightly more interest than simple interest loans.
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