What is Rule of 78 and how can it impact loans?

Key takeaways

• Rule of 78 can only be used on loans lasting less than 61 months.

• If a lender uses this rule, you’ll pay more toward interest in the first months of repayment.

• Not many lenders use the Rule of 78, as it has been banned in some states.

Some lenders use a tricky strategy known as the Rule of 78 to ensure you pay more for your loan up front, thanks to pre-calculated interest charges. Though this practice is banned in some states, others allow it for loans longer than 61 months. If a lender applies the rule of 78, paying off your loan early could cost you more than expected.

What is the Rule of 78?

When the Rule of 78 is implemented, you pay interest in a way that ensures that the lender gets its share of profit even if a loan is paid off early. It’s a method of calculating and applying interest on a loan that allocates a larger portion of the interest charges to the earlier loan repayments.

Though it was outlawed in 1992 for loans longer than 61 months, some lenders still use this practice. It’s widely viewed as unfair to borrowers who may decide to pay off their loans early to save money on interest.

How the Rule of 78 works against borrowers

The interest structure of the Rule of 78 is designed to favor the lender over the borrower.

“If a borrower pays the exact amount due each month for the life of the loan, the Rule of 78 will have no effect on the total interest paid,” says Andy Dull, vice president of credit underwriting for Freedom Financial Asset Management, a debt relief company. “However, if a borrower is considering the possibility of paying off the loan early, it makes a real difference. Under the terms of the Rule of 78, the borrower will pay a much greater portion of the interest earlier in the loan period.”

In other words, you’ll save less by making additional payments ahead of schedule than if the lender charged simple interest.

The Rule of 78 formula

To use the Rule of 78 on a 12-month loan, a lender adds the digits within the 12 months using the following formula:

1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78

Note that a 12-month loan comes with a rule of 78, but a 24-month loan would follow the rule of 300 since the numbers would add up to that amount. Loans that last 36 months, 48 months and so on would follow the same format.

The lender allocates a fraction of the interest for each month in reverse order. For example, you would pay 12/78 of the interest in the first month of the loan, 11/78 of the interest in the second month and so on. The result is that you pay more interest than you should.

Additionally, the Rule of 78 ensures that any extra payments you make are treated as prepayment of the principal and interest due in subsequent months.

How the Rule of 78 affects loan interest

Under the Rule of 78, a lender weighs interest payments in reverse order, with more weight given to the earlier months of the loan’s repayment period. According to this rule, if you took out a 12-month loan with a total interest charge of $2,000, this is how much you’d pay in interest each month.

As you can see, with the Rule of 78, early payments are more interest-heavy.

Rule of 78 vs. simple interest

While the Rule of 78 can be used for some types of loans (usually for subprime auto loans), there is a much better (and more common) method for lenders to use when computing interest: the simple interest method.

With simple interest, your payment is applied to the month’s interest first, with the remainder of the monthly payment reducing the principal balance. Simple interest is only calculated on the principal of your loan amount, so you never pay interest on the accumulated interest.

Unlike the Rule of 78, where the portion of the interest you pay decreases each month, simple interest uses the same daily interest rate to calculate your interest payment each month. The amount you pay in interest will still go down as you pay off your loan since your principal balance will shrink, but you’ll always use the same number to calculate your monthly interest payment.

Using the Rule of 78, a $5,000 personal loan with an interest rate of 11 percent over 48 months and a $150/mo payment would incur an interest charge of $89.80 in the first month. Meanwhile, if the lender uses the simple interest method, your interest charge in the first month would be $45.83 — almost 50 percent less.

How can you tell if a lender uses the Rule of 78?

During the financing process, your lender might not always point out whether your loan agreement applies the Rule of 78 to its interest calculation. That’s why reading your loan agreement carefully is so important.

Look for mentions of the Rule of 78 or precomputed interest in your agreement.

If it mentions an interest refund, that might be a cue for you to ask deeper questions about how your lender computes the interest for your loan. Some lenders that apply Rule of 78 to your loan include fine print about how it handles an interest rebate or refund in case you decide to pay the loan in full before the full repayment period ends.

If there isn’t specific language about the Rule of 78 in your agreement, asking them is the clearest way to know if the lender uses this interest method.

The bottom line

Fortunately, the Rule of 78 has largely disappeared even in instances where its use would still be legal. You likely don’t need to worry about it unless you’re a subprime borrower seeking an auto loan or a personal loan that lasts for 60 months or less.

But, lenders that still use the Rule of 78 want to make as much money from financing your loan as legally possible. Even if you don’t intend to pay off your loan early, it’s always a good idea to understand how your loan interest is calculated if you change your repayment strategy.