The Rule of 78s – How to Avoid a Debt Trap

The Rule of 78s is a financing method that uses pre-determined interest on short-term loans.  This financing practice is considered controversial because most financial analysts believe the practice is unfair to the consumer.

Because the interest on the loan is pre-computed, this means nearly all of the interest on the loan is paid first – before any principal payments are made. So if the loan is paid off early, the lender makes a profit on the borrower because all of the interest that traditionally is tacked on monthly is paid up front.

How the Rule of 78s Started

The Rule of 78s can be traced back to Indiana in 1935, immediately after the Great Depression. Lenders were typically doling out smaller amounts to borrowers over a period of 12 months with the unearned portion of the loans’ interest calculated at the time of disbursement of funds.

The number 78 comes from the sum of the monthly term:  1 to 12 (1+2+3+4+5+6+7+8+9+10+11+12= 78).  Thus, the Rule of 78s is born.

Who Uses the Rule of 78s?

The Rule of 78s isn’t commonly used today, but it does show up related to car loans. Consumers are urged to beware of any type of pre-computed loan because it leaves the borrower at a disadvantage should the borrower pay off the loan in full early.

Many states have passed laws making it illegal to offer a pre-computed loan with a term longer than 61 months. Most car loans have terms of 36, 42, 48 and 60 months, although sometimes dealers will finance cars longer than 60 months.

Glossary of Terms

There are certain terms that borrowers need to be familiar with when considering entering into an agreement using pre-computed financing methods.

Understanding these terms will help consumers make a more educated decision about how they choose to enter into a binding financial agreement.
  • Lender: A person or organization that gives money to a borrower with the expectation that the money will be repaid in an agreed upon time frame.
  • Borrower: A person or company that receives money from another party with the agreement to pay the money back, usually with interest, over a specific period of time.
  • Repayment: The act of paying off debts.
  • Interest: Money that is paid in exchange for borrowing money- the interest is calculated as a percentage of the month borrowed.
  • Principal: The actual amount of money borrowed.

Understanding the Rule

Sometimes the Rule of 78s can be an option for borrowers, but it is important for them to understand how this type of pre-computed interest works, how it can affect their future financial standing and if they have any other more concrete financing options available to them.

As always before entering into a financial agreement, it is smart to make an educated decision. The best starting place is to know your credit score so you can figure out what options are available to you before you start shopping around.

Then do your research. Browse around on the Internet so you know where to go for your loan and what to expect. Knowing all your options will help you make a sound financial decision.

Bill Fay

Bill Fay is a journalism veteran with a nearly four-decade career in reporting and writing for daily newspapers, magazines and public officials. His focus at Debt.org is on frugal living, veterans' finances, retirement and tax advice. Bill can be reached at bfay@debt.org.

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