The Rule of 78 & Precomputed Interest

The Rule of 78 is a financing method that allocates pre-calculated interest charges that favor the lender over the borrower on short-term loans.

The Rule of 78 can be traced back to Indiana in 1935, immediately after the Great Depression. Over time, this financing practice became controversial, and in 1992 was outlawed in the United States for loans longer than 61 months. Some individual states have their own laws for loans shorter than 61 months; about half the states have outlawed the Rule of 78 loans completely.

The Rule of 78 loan is also known as the “sum of the digits,” because the digits of the 12 months in a one-year loan (1+2+3, etc.) add up to 78.

With this loan, borrowers are required to pay more interest in the early months of the loan. This is why financial analysts believe the Rule of 78, also known as “pre-computed loans,” is unfair to consumers. That’s because it penalizes anyone who pays off a loan early, though the penalty is not always severe.

For example, if you have a 24-month, $10,000 simple interest loan at 5% and decide to pay it off after just 12 months, you would save a total of $4.48 over what you would pay if you used a Rule of 78 loan with the same conditions.

That being said, Rule of 78 loans clearly favor lenders, because more interest is paid early in the loan. If a 12-month loan is paid early, the lenders still receive a good share of the total interest charge. The borrower is not rewarded for being responsible for paying the loan off before the term is completed.

Lenders who promote this loan are usually involved in sub-prime or payday loans. Dealerships or loan agents that advertise “Buy Here, Pay Here” financing are prime locations. If you hear salesmen mention things like “refund” or “rebate of interest” when discussing loan terms, be skeptical about what comes next.

You likely are being challenged to know that a “pre-computed loan” is being offered and it could cost you if you pay the loan off early.

How the Rule of 78 Works

Borrowers should know this important fact: If you make all the payments over the prescribed length of a loan – 24 payments on a two-year loan, 36 payments on a three-year loan, etc. – you will pay the same amount of interest for a Rule of 78 Loan as you would a simple interest loan.

The difference occurs if you pay the loan off early.

In other words, paying off a two-year loan in just 12 months or a three-year loan in 24 months is when a Rule of 78 Loan favors the lender.

The rule of 78 methodology calculates interest for the life of the loan, then allocates a portion of that interest to each month, using what is known as a reverse sum of digits. For example, if you had a 12-month loan, you would add the numbers 1 through 12 (1+2+3+4, etc.), which equals 78.

From there, you would pay 12/78 of the interest the first month; 11/78 of the interest the second month, and so on down to 1/78 of the interest the final month.

It is important for borrowers to understand how this type of pre-computed interest works, how it can affect their future financial standing, and if they have any other more concrete financing options.

As always before entering into a financial agreement, it is smart to make an educated decision. The best starting place is to know your credit score so you can figure out what options are available before you start shopping around.

Then do your research. Browse around on the Internet so you know where to go for your loan and what to expect. Knowing all your options will help you make a sound financial decision.

Rule of 78 Formula

Most loans are simple interest. You agree to an interest rate with a lender for a set amount of time. If it’s 12 months, the amount borrowed, the principal, is divided by 12. The interest rate is then charged to the remaining principal.

With simple interest, the interest paid each month gets lower as the principal gets lower. With the Rule of 78, a higher interest rate is charged early in the loan.

Let’s take a look at a 12-month, $5,000 loan at 12% interest and compare the interest charges with simple interest to Rule of 78 interest.

As you can see, a Rule of 78 loan has a slightly higher interest in the initial months, but that lowers as the loan is paid. As we explained, the difference is not monumental, but it can add up with larger loans and larger interest rates.

Comparing the Rule of 78 to Simple Interest Loans

Nearly all car loans these days are calculated using simple interest, which is calculated by multiplying the principal x the daily interest rate x the number of days between payments.

If you borrow $10,000 to purchase a car at 5% interest with a two-year loan, you will pay a total of $529.13 in interest, whether you use a simple interest loan or a Rule of 78 Loan.

On a simple interest loan, the amount of interest is amortized each month, meaning the amount of interest paid each month changes because it’s based on the amount of principal, which declines with each payment. We showed that in our example above.

On a Rule of 78 loan, more interest is paid in the initial months.

Using the Rule of 78 Loan, you would have paid $391.50 in interest after 12 months. Using a simple interest loan, you would have paid $389.29, a difference of $2.21. Again, it’s not a lot.

If you pay the loan early, say after 12 months, you’d pay $2.27 more in interest with a Rule of 78 loan. Again, it’s not a huge figure.

How to Tell if a Lender Uses Precomputed Interest Loans

A lender may not admit up front it is using a precomputed interest loan (or Rule of 78). But it’s important for you to know the terms so you’re aware.

Read the fine print. No, it’s not fun to read the details of a loan agreement, but it is important.

Any mention of Rule of 78 or precomputed interest will tell you the loan is not simple interest and will have larger interest payments early in the loan.

If the agreement mentions an interest refund, pay attention. That tells you to ask directly about the interest calculation for the loan.

If there is no language in the agreement about Rule of 78, it’s wise to ask if the lender is offering that kind of loan.

Better Lending Options

Though the Rule of 78 loan really isn’t that much more expensive, many of us may not wish to reward lenders with more interest in the early months of repayment.

For those borrowers, there are better options, with several different loan types that may help. Here are a few options:

• Simple Interest Loans: Interest is calculated on the outstanding balance, so as you pay down the principal, the interest decreases. This means you can save money if you pay off the loan early.
• Credit Union Loans: Credit unions can often offer better interest rates and more favorable terms compared to traditional banks. This is because they are not-for-profit institutions.
• Home Equity Loans: If your house is worth more than your remaining mortgage, a home equity loan may help. Home equity loans and home equity lines of credit use the home as collateral, so interest rates will be lower than credit card charges.
• Debt Management Programs: If you plan to use the loan to consolidate and pay off credit card debt, a debt management program could be a better option. Nonprofit credit counseling agencies have agreements with creditors to lower interest rates and consolidate payments.

Other Financial Advice

Before taking a risk on any kind of loan, it’s wise to speak with a nonprofit credit counselor, who will evaluate your personal financial situation and offer solutions. A credit counselor will address the causes that led to debt, and find a solution that works best for each individual situation.

While a Rule of 78 loan may not seem onerous compared to a simple interest loan, it’s best to gain as much knowledge as you can about that loan, and options.