What Is the Rule of 78 for Loans and Interest?
Understand the Rule of 78, an interest calculation method that front-loads loan costs. Learn its mechanics and why it's now largely restricted.
The Rule of 78 is a specific method lenders historically used to calculate and allocate interest charges on fixed-term loans. This technique primarily impacts how interest is distributed over the life of a loan, particularly when a borrower repays the loan earlier than scheduled. While the total interest paid remains the same if the loan runs to its full term, this method front-loads a larger portion of the interest into the initial payments. This approach significantly reduces the potential interest savings for borrowers who choose to pay off their loans ahead of schedule.
Understanding the Rule of 78
The Rule of 78, also known as the “sum-of-the-digits” method, is an accelerated interest allocation technique. This contrasts with a simple interest loan, where interest accrues based on the outstanding principal balance, leading to more evenly distributed interest payments over time.
The “78” in the name refers to the sum of the digits from 1 to 12 (1+2+3+…+12 = 78), which is the denominator for a 12-month loan. For loans with different terms, the denominator is the sum of the digits corresponding to that loan’s total number of months.
How the Rule of 78 Works
The mathematical mechanics of the Rule of 78 rely on assigning a decreasing fraction of the total precomputed interest to each payment period. To calculate the denominator, one sums the integers representing each month of the loan term. For instance, a 6-month loan would have a denominator of 21 (1+2+3+4+5+6 = 21).
The interest portion for each payment is then determined by applying a fraction, where the numerator is the number of months remaining in the loan, counted in reverse, and the denominator is the sum of the digits. For example, in a 6-month loan, the first month’s interest would be 6/21 of the total interest. The second month would be 5/21, and this pattern continues until the last month, which would be 1/21.
Consider a hypothetical 6-month loan with a total precomputed interest of $100. In the first month, $28.57 (6/21 of $100) would be allocated to interest. The second month would see $23.81 (5/21 of $100) allocated, and so on. By the third month, $19.05 (4/21) would be interest, and by the end of the third month, $71.43 of the total $100 interest would have already been accounted for.
The rebate of unearned interest upon early payoff is significantly smaller than it would be with a simple interest loan. The principal balance decreases much slower in the early stages, resulting in less interest savings for early repayment.
Historical Context and Current Legality
The Rule of 78 gained prominence as a simpler method for calculating interest on short-term installment loans, particularly before widespread computing capabilities. Lenders often used it for auto or personal loans. This method protected lenders from potential losses if borrowers repaid their loans prematurely.
However, due to its perceived unfairness to borrowers, particularly those who paid off loans early, the use of the Rule of 78 has been significantly restricted or outlawed in many jurisdictions. Federal regulations in the United States prohibit its use for consumer credit transactions with terms exceeding 61 months, as established in 1992.
Many individual states have also implemented their own laws, with some completely banning the Rule of 78 for consumer loans, regardless of term length. Other states may permit its use only under specific conditions or for certain types of loans, often requiring clear disclosure. This shift reflects a broader move towards consumer protection and the more transparent simple interest calculation, where interest is calculated solely on the outstanding principal balance.