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
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.
How do you explain the Rule of 78? ›
The idea is to weight the interest so that you pay more of it in the early stages of the loan, but still pay the same amount of total interest as you would with a simple interest formula. As you can see, the sum of the monthly digits for a one-year loan equals 78, demonstrating why this method is dubbed the Rule of 78.
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.
How does loan calculation work? ›
EMI Calculation Formula with Example
The lending institution has offered a loan with an annual interest rate of 7.2% for a tenure of 10 years. EMI = Rs 10,00,000 * 0.006 * (1 + 0.006)120 / ((1 + 0.006)120 – 1) = Rs 11,714. Hence, you will be paying the EMI of Rs 11,714 every month for 10 years.
What is the difference between simple interest and the Rule of 78? ›
Using the Rule of 78, a $5,000 personal loan with an interest rate of 11 percent over 48 months and a $150/mo payment would incur an interest charge of $89.80 in the first month. Meanwhile, if the lender uses the simple interest method, your interest charge in the first month would be $45.83 — almost 50 percent less.
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.
How is reducing balance loan calculated? ›
What's the formula for calculating reducing balance interest rate? the interest payable (each instalment) = Outstanding loan amount x interest rate applicable for each instalment. So, after every instalment, your principal amount decreases, which in turn reflects on the effective interest rate.
What is the Rule of 78 loan formula? ›
2. Familiarize yourself with the formula: The Rule of 78 formula can be written as follows: Interest = (Loan amount x Interest rate x Number of remaining months) / (n(n+1)/2), where n represents the total number of months in the loan term.
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.
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.
Lenders look at a debt-to-income (DTI) ratio when they consider your application for a mortgage loan. A DTI ratio is your monthly expenses compared to your monthly gross income. Lenders consider monthly housing expenses as a percentage of income and total monthly debt as a percentage of income.
How do lenders calculate loan to value? ›
To figure out your LTV ratio, divide your current loan balance (you can find this number on your monthly statement or online account) by your home's appraised value. Multiply by 100 to convert this number to a percentage. Caroline's loan-to-value ratio is 35%.
How does a lender determine loan amount? ›
A maximum loan amount describes the total sum that one is authorized to borrow on a line of credit, credit card, personal loan, or mortgage. In determining an applicant's maximum loan amount, lenders consider debt-to-income ratio, credit score, credit history, and financial profile.
What are the alternatives to the Rule of 78? ›
Simple Interest Method: Unlike the Rule of 78, the simple interest method calculates interest based on the outstanding principal balance of the loan. This means that as the principal balance decreases, the interest charged also decreases.
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 for precomputed loans? ›
The rule of 78 is one of the main tactics — and the basis for precomputed interest auto loans. Lenders add up all the months in the year, which total 78, and then apply interest in reverse order. During a one-year loan, you would pay 12/78 of the total interest due in the first month.
How would you explain the meaning of the rule of law? ›
Rule of law is a principle under which all persons, institutions, and entities are accountable to laws that are: Publicly promulgated. Equally enforced. Independently adjudicated. And consistent with international human rights principles.
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.
What is the Rule of 78 for recurring revenue? ›
Typically, the Rule of 78 is used with sales quotas. If a salesperson must bring in a set amount of new revenue each month and that revenue is recurring, you can multiply the quota X 78 to get the total amount each salesperson will bring in for the year.
