What Is Rule 78 and How Does It Affect Your Loan?

The Rule of 78 is a method for allocating interest on installment loans. It represents a historical approach to distributing interest payments over a loan’s duration. While it served a purpose in earlier lending practices, its implications for borrowers, particularly concerning early loan payoffs, are distinct from other interest calculation methods.

Understanding Rule 78

The Rule of 78 is a technique for calculating interest on loans, often referred to as the “sum of the digits” method. Its primary function is to assign a greater portion of the total interest to the initial payments of an installment loan. Lenders historically used this method due to its administrative simplicity. This approach ensures that a larger share of the overall interest is collected by the lender in the early stages of a loan.

Calculating Interest Allocation

The calculation for the Rule of 78 involves summing the digits representing the number of payment periods in a loan term. For instance, a 12-month loan would sum the numbers from 1 to 12 (1+2+3+…+12), which totals 78. This sum becomes the denominator in a fraction used to determine the proportion of the total interest allocated to each payment period.

The numerator for each period is derived by counting down the remaining periods. So, for a 12-month loan, the first month’s interest allocation would use 12/78ths of the total interest, the second month would use 11/78ths, and so on, until the last month uses 1/78th. For example, in a 12-month loan, the first month accounts for roughly 15.4% of the total interest (12/78), while the last month accounts for only about 1.3% (1/78).

Implications for Borrowers

The practical consequence of the Rule of 78 is particularly noticeable for borrowers who pay off their loans early. Because a disproportionately large share of the total interest is allocated to the initial payments, an early payoff under this method results in less interest savings than what might be expected with a simple interest or actuarial method. If the loan is paid off over its full term, the total interest paid remains the same as with a simple interest loan, but the distribution of that interest across payments differs significantly.

This front-loading means that even if a borrower prepays a loan halfway through its term, they would have already paid a substantial majority of the total interest, limiting their potential savings. The Rule of 78 prioritizes the lender’s interest recovery in the event of early termination.

Current Usage and Legality

The contemporary relevance of the Rule of 78 has diminished significantly. Many jurisdictions, particularly for consumer loans, have restricted or prohibited its use due to its perceived unfairness to borrowers who pay off loans ahead of schedule. Federal regulations, such as those related to the Truth in Lending Act, prohibit its use for mortgages and consumer loans with terms exceeding 61 months.

While it may still be encountered in some specific types of loans, older contracts, or in jurisdictions with less stringent regulations, the Rule of 78 is largely phased out for new consumer credit in the United States. Its decline reflects a shift towards more transparent interest calculation methods that benefit borrowers for early repayment.