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.
What is the Rule of 78s calculation? ›
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 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.
How do you calculate borrowing? ›
Divide your interest rate by the number of payments you'll make that year. If you have a 6 percent interest rate and you make monthly payments, you would divide 0.06 by 12 to get 0.005. Multiply that number by your remaining loan balance to find out how much you'll pay in interest that month.
What is a calculation of the amount of interest determined at the beginning of the loan and then added to the principal? ›
Add-on interest is a method of calculating the interest to be paid on a loan by combining the total principal amount borrowed and the total interest due into a single figure, then multiplying that figure by the number of years to repayment.
What is the Rule of 78 on a loan? ›
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 the Rule of 72 and how do you calculate using this rule? ›
The Rule of 72 is a calculation that estimates the number of years it takes to double your money at a specified rate of return. If, for example, your account earns 4 percent, divide 72 by 4 to get the number of years it will take for your money to double. In this case, 18 years.
How do lenders calculate loan amount? ›
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.
How do mortgage lenders calculate loan? ›
Mortgage lenders use a calculation known as the debt-to-income ratio (DTI) to determine how much home you can afford. The DTI ratio is calculated by dividing your monthly debt obligations by your gross monthly income.
The monthly payment on a $70,000 loan ranges from $957 to $7,032, depending on the APR and how long the loan lasts. For example, if you take out a $70,000 loan for one year with an APR of 36%, your monthly payment will be $7,032.
How much would a $50,000 loan cost per month? ›
Here's what a $50,000 loan would cost you each month
| 8.00% |
|---|
| Two-Year Repayment | $2,261.36/month, $4,272.75 in interest over time |
| Seven-Year Repayment | $779.31/month, $15,462.10 in interest over time |
| 10-Year Repayment | $606.64/month, $22,796.56 in interest over time |
Jan 20, 2024
To calculate interest rates, use the formula: Interest = Principal × Rate × Tenure. This equation helps determine the interest rate on investments or loans.
How much of a mortgage goes to the principal? ›
After a year of mortgage payments, 31% of your money starts to go toward the principal. You see 45% going toward principal after ten years and 67% going toward principal after year 20.
What is the formula for the monthly payment? ›
Monthly Payment = (P × r) ∕ n
Again, “P” represents your principal amount, and “r” is your APR. However, “n” in this equation is the number of payments you'll make over a year. Now for an example. Let's say you get an interest-only personal loan for $10,000 with an APR of 3.5% and a 60-month repayment term.
What is the rule of 78s to determine prepayment penalties? ›
For example, prepaying after 2 months would result in the lender being able to keep 23/78 or approximately 29.5 percent of the finance charges. For another example, if the borrower prepays after 6 months, the lender would have earned 57/78s or approximately 73 percent of the finance charges.
How to calculate interest refund? ›
Interest is calculated using the compound interest formula of: (((1 + (RATE/NBR OF DAYS IN YR)) ^ NO OF DAYS) - 1) MULTIPLIED BY THE BILL/REFUND AMOUNT. Basically, each day the amount is outstanding, interest accrues at the rate in effect for that day.
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.
What is the rule of 70 and how is it calculated? ›
The rule of 70 is used to determine the number of years it takes for a variable to double by dividing the number 70 by the variable's growth rate. The rule of 70 is generally used to determine how long it would take for an investment to double given the annual rate of return.
