What Is the Rule of 78 and How Does It Work?
Learn about the Rule of 78, a historical interest calculation method that front-loaded costs, impacting early loan repayments for borrowers.
The Rule of 78 is a method lenders have historically used to calculate interest charges on an installment loan. This approach ensures that a larger portion of the total interest is recognized and paid by the borrower in the early stages of a loan’s term. While it impacts how interest is allocated over time, the total interest paid remains the same if the loan runs its full course as originally scheduled.
Understanding the Rule of 78
The Rule of 78 is an accelerated method of interest computation, designed to front-load interest payments. The underlying principle of this method is derived from the “sum of the digits” for the number of payment periods. For instance, in a 12-month loan, the sum of the digits from 1 to 12 (1+2+3+…+12) equals 78, which gives the rule its name.
Lenders historically favored this method to protect their potential interest income, especially if a borrower decided to pay off a loan early. By collecting a greater share of the interest upfront, lenders could compensate for administrative costs or lost future interest income that might otherwise occur with an early payoff. This approach was particularly common for fixed-rate installment loans.
The Calculation Method
The mathematical application of the Rule of 78 centers on the sum of the digits for the loan’s term. For a 12-month loan, the sum is 78. For a 24-month loan, the sum of digits from 1 to 24 is 300. This sum forms the denominator in a fraction used to allocate a portion of the total precomputed interest to each payment period.
To illustrate, consider a 12-month loan with a total precomputed interest of $54.98. In the first month, the interest allocated would be 12/78 of the total interest. This calculation amounts to (12/78) $54.98 = $8.46. For the second month, the allocated interest would be 11/78 of the total, resulting in (11/78) $54.98 = $7.75. This pattern continues, with the interest portion decreasing each month until the final month, where only 1/78 of the total interest is allocated, equaling $0.70 in this example.
This step-by-step allocation clearly demonstrates how the interest portion of each payment decreases over time, while the amount applied to the principal consequently increases. This method is applied to the entire precomputed interest amount for the life of the loan.
Impact on Loan Repayment and Modern Use
The Rule of 78 significantly impacts borrowers who choose to repay their loans ahead of schedule. Because a larger share of the total interest is concentrated in the early months, prepaying a loan calculated using this rule results in less interest savings than a borrower might expect compared to a simple interest loan. In a simple interest loan, interest is continuously calculated on the declining principal balance, allowing for greater savings with early payments.
Due to its disadvantageous nature for borrowers, the use of the Rule of 78 has been largely restricted or outlawed for many consumer loans in the United States. Federal legislation in 1992, under the Truth in Lending Act, prohibited its use for loans with terms exceeding 61 months. Many individual states have implemented their own laws, with some completely banning the practice for any loan duration, while others restrict it to loans under a certain term, such as 60 months.
Despite these restrictions, the Rule of 78 may still be encountered in very short-term loans, certain commercial agreements, or older contracts that predate the regulatory changes. Lenders are generally required to disclose the method of interest calculation. Borrowers are encouraged to review loan agreements carefully and inquire about the interest calculation method to understand how early repayment might affect their total costs.