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
How is the Rule of 78 loan calculated? ›
The denominator of a Rule of 78s loan is the sum of the integers between 1 and n, inclusive, where n is the number of payments. For a twelve-month loan, the sum of numbers from 1 to 12 is 78 (1 + 2 + 3 + . . . +12 = 78). For a 24-month loan, the denominator is 300.
What is the Rule of 78 loan calculator? ›
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.
Does the Rule of 78 apply to mortgages? ›
Federal law generally stipulates that in some cases — like mortgage refinances and other types of consumer loans with precalculated interest — lenders can't apply the Rule of 78 to loans with repayment periods of longer than 61 months.
How to count rule 78? ›
According to “Rule of 78”, the denominator of the loan with a 24-month tenor is the sum of the numbers 1 to 24 added together, which is 300 (24 + 23 + 22 + …… + 1 = 300). Hence, 24/300ths of the total interest is allocated as the portion to be paid in the 1st month.
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 is the Rule of 78 simplified? ›
Using the Rule of 78, you can calculate the amount of interest you would pay if you paid off the loan early. In this case, since it's a one-year loan, the sum of the digits is 78. If you were to pay off the loan after six months, you'd calculate the prepayment penalty using the remaining months of the loan.
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 in Excel? ›
The Rule of 78 formula is simple. 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.
To calculate a personal loan settlement, assess the outstanding balance, including interest and fees. Propose a reasonable settlement amount, often a percentage of the total owed. Negotiate terms with the lender, considering your financial circ*mstances.
What is the Rule of 78 for early settlement? ›
Lenders often favor the Rule of 78 because it maximizes their returns, particularly on loans that might be settled early. This method ensures that a large portion of the loan's interest is paid within the first few months, protecting the lender's interest in the event of early repayment.
How to calculate early repayment of loan? ›
How is a personal loan early repayment charge calculated?
- The remaining interest.
- 1% of the amount repaid early, if there is more than a year left of the repayment term.
- 0.5% of the amount repaid early, if there is less than a year left of the repayment term.
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 does 78 loan to value mean? ›
Your lender is required by federal law to cancel PMI when a home's LTV ratio is 78% or lower than the home's original appraised value (provided certain requirements are met). This cancellation is generally preplanned for when your loan balance reaches that percentage.
How to calculate 80% loan to value? ›
Loan to Value Ratio = Loan Balance / Property Value
For example: a $400,000 loan on a $500,000 commercial property would have an LTV of 80% ($400,000 / $500,000 = 0.80).
Does the rule of 72 really work? ›
The accuracy of the rule of 72
For instance, if you were to invest $100 at 9% per annum, then your investment would be worth $200 after 8.0432 years, using an exact calculation. The rule of 72 gives 72/9 = 8 years, which is close to the exact answer.”
