The Rule of 78 – How to Avoid a Debt Trap

    The Rule of 78 is a financing method that allocates pre-calculated interest charges that favor the lender over the borrower on short-term loans.

    This financing practice is highly controversial and in 1992, was outlawed in the United States for loans longer than 61 months. Individual states have their own laws for loans shorter than 61 months and 17 states outlawed it completely.

    Financial analysts believe the Rule of 78, also known as “pre-computed loans” is unfair to consumers because it penalizes anyone who pays off a loan early, though the penalty is really not that severe.

    For example, if you have a 24-month, $10,000 simple interest loan at 5% and decide to pay it off after just 12 months, you would save a total of $4.48 over what you would pay if you used a Rule of 78 loan with the same conditions.

    Lenders who promote this method are usually involved in sub-prime, used automobile business. Dealerships that advertise “Buy Here, Pay Here” financing are prime locations. If you hear salesmen mention things like “refund” or “rebate of interest” when discussing loan terms, be skeptical about what comes next.

    You likely are being challenged to know that a “pre-computed loan” is being offered and it could cost you, if you pay the loan off early.

    How the Rule of 78 Works

    Consumers should know that if they make all the payments over the prescribed length of a loan – in other words, 24 payments on a two-year loan, 36 payments on a three-year loan, etc. – they will pay the same amount of interest for a Rule of 78 Loan as they would a simple interest loan.

    The difference occurs if the consumer pays the loan off early.

    In other words, paying off a 2-year loan in just 12 months or a 3-year loan in 24 months. is when a Rule of 78 Loan becomes lopsided in favor of the lender.

    The rule of 78 methodology calculates interest for the life of the loan, then allocates a portion of that interest to each month, using what is known as a reverse sum of digits. For example, if you had a 12-month loan, you would add the numbers 1 through 12 (1+2+3+4, etc.) which equals 78. That’s where this method got its name.

    From there, you allocate portions of the interest due to each month in reverse order. In other words, you would pay 12/78 of the interest the first month; 11/78 of the interest the second month and so on down to 1/78 of the interest the final month.

    Comparing the Rule of 78 to Simple Interest Loans

    These days, nearly all car loans are calculated using simple interest loans, which is calculated by multiplying the principal x the daily interest rate x the number of days between payments.

    So, if you borrow $10,000 to purchase a car at 5% interest, you will pay a total of $ 529.13 in interest, whether you use a simple interest loan or a Rule of 78 Loan.

    On a simple interest loan, the amount of interest is amortized each month, meaning the amount of interest paid each month changes because it’s based on the amount of principal, which declines with each payment.

    The interest paid the first month is $41.67 and it goes down each month, until you pay just $1.82 the final month. If you pay the car off 12 months early, you would pay 389.29 of interest.

    Compare that to a two-year Rule of 78 Loan on $10,000 at 5% interest. First, you take the simple interest value of the loan over two years at 5%, which is $529.13.

    Then add the 24 digits (1+2+3+4 and so on up to 24) and your total is 300.

    Now multiply the amount of interest ($529.13) times the sum of digits and apply in reverse proportion. So, the first payment would be 529.13 x (24 divided by 300) = $42.33, which is the amount of interest you would pay the first month.

    The second month would be 529.13 x (23 divided by 300) = $40.56. The third month would be 529.13 x (22 divided by 300) = $38.80 and so on.

    Using the Rule of 78 Loan, you would have paid $391.50 of interest after 12 months. Using a simple interest loan, you would have paid $389.29, a difference of $2.21.

    The payoff amount for the simple interest loan after 12 months would be $5,124.71. The payoff amount for the Rule of 78 loan would be $5,126.98, a difference of $2.27. The total amount saved would be $4.48.

    How the Rule of 78 Started

    The Rule of 78 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 on a one-year loan:  1 to 12 (1+2+3+4+5+6+7+8+9+10+11+12= 78).  Thus, the Rule of 78 is born.

    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.
    • Amortize: The proportion of interest paid vs. principal paid that changes every month.

    Understanding the Rule

    Sometimes the Rule of 78 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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