Understanding The Rule of 78 And How Lenders Use It
Mar 24, 2023 By Kelly Walker

Several financial institutions employ the Rule of 78 when determining a borrower's interest rate. The Rule of 78 mandates that a larger interest share is paid at the beginning of a loan cycle, reducing the borrower's potential savings.

What Does 78 Mean?

When interest is calculated using the Rule of 78, the lender will receive its fair part of the profit regardless of whether or not the loan is repaid early. It's a way to figure out how much interest to add to your loan and then apply it to subtract more from your principal as you pay it off faster.

Some lenders are still using the 78-day guideline. It's seen as unjust for borrowers who want to get ahead of their debt by paying off their loans early. Under Rule 78, interest payments are prioritized backwards, prioritizing the earliest months of the loan's repayment tenure.

Realizing the Value of 78

The Rule of 78 prioritizes calculating interest to the first few months of a borrower's loan cycle, increasing the lender's profit. The most common application of this interest computation schedule is for fixed-rate, non-revolving loans. Borrowers considering prepaying their debts should keep the Rule of 78 in mind.

How To Determine Interest Using the Rule of 78

The interest calculation for a loan using the Rule of 78 involves more than an annual percentage rate (APR) calculation. Nonetheless, if the borrower makes payments for the whole loan cycle without prepayment, the interest paid will be the same for both types of loans.

According to the Rule of 78 technique, months from a loan's initial cycle are given priority. Short-term instalment lenders who focus on subprime clients utilize this method. The Rule of 78 refers to the sum of all the numbers in a one-year loan equals 78.

The sum of the numbers for a two-year loan comes to $300. After adding up all the months, the lender gives more weight to the interest payments for the earlier months. The first month's interest on a loan for a year would be 12/78 of the total claim

The second month would be 11/78; the third month would be 10/78, etc. A two-year loan would have a monthly weighting factor of 24/300 in the first month, 23/300 in the second, 22/300 in the third, etc.

Difference Between the Rule of 78 and Simple Interest

The total amount owed on loan is divided into the principal and the interest. According to Rule 78, interest is allocated more heavily toward earlier payments than later ones. If the loan is not paid off early or returned in full, the total interest paid under simple interest and the Rule of 78 will be the same.

Paying off a loan will result in higher interest due to the Rule of 78, which gives greater weight to interest paid earlier in the loan's term. Loans in the United States with periods more than 61 months have been prohibited by law since 1992.

Several jurisdictions have enacted stricter regulations for loans with terms of 61 months or less, while others have abolished the practice altogether.

How Can You Know If Your Lender Applies The Rule Of 78?

A lender's failure to mention Rule 78 in the context of interest computation throughout the financing procedure is possible. This is why it's essential to read your loan agreement thoroughly. You should review your contract for references to the Rule of 78 or precomputed interest.

A refund of interest might be a red flag that you need to dig more into how your lender calculates interest. You should read the fine print of any loan agreement carefully because certain lenders that utilize Rule 78 will have specific policies on interest rebates and refunds if you pay off the loan in full before the end of the repayment period.

The Rule of 78 is an interest calculation technique that may or may not be used by your lender; if it is not explicitly stated in your agreement, the best way to determine this is to question your lender directly.

Conclusion

It would be best to avoid instalment loans that apply the Rule of 78 since they make it difficult to pay them off early. Even in situations when it may be technically used, the Rule of 78 has thankfully fallen out of favour. Unless you're a low-credit-score borrower looking for a car loan with a term of 60 months or less, you can ignore this concern.

Remember that the traditional Rule of 78 lenders wants to earn as much money as possible from funding your loan. It's essential to know how your loan's interest is calculated even if you have no plans to prepay your loan in case you decide to switch your repayment plan midway through the term.