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Rule of 78



Definition

The Rule of 78 is an approach lenders use to calculate the interest on a loan with a pre-determined payoff schedule. It front-loads the interest, meaning that in the early stages of repayments, a larger portion of the payment goes towards interest rather than the principal. This rule is named after the sum of the digits 1 through 12, which equals 78.

Phonetic

The phonetics of the keyword “Rule of 78” is: rool uv sev-uh n-tee ayt

Key Takeaways

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  1. The Rule of 78 is a method of allocating the interest charge on a loan across its payment periods.
  2. It assigns a higher interest rate during the early stages of a loan, depreciating towards the end stages. This is advantageous for lenders, as they earn most of the interest during the initial period of the loan.
  3. However, this method can be disadvantageous for borrowers, particularly those who wish to pay off their loan early, as they would end up paying a greater amount of interest compared to the ‘simple interest’ method.

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Importance

The Rule of 78 is a method used by some lenders to calculate the amount of interest charged on a loan. It’s important because it front-loads the interest, meaning the borrower pays more interest at the beginning of the loan term and less at the end. This is advantageous to lenders as they can recover a large portion of the loan’s interest early on, reducing their risk. For borrowers, it can be disadvantageous, especially if they want to pay off their loan early, as they will have paid a large proportion of the loan’s interest even though their loan tenure was cut short. Understanding the Rule of 78 can help borrowers make more informed decisions when comparing loan options.

Explanation

The Rule of 78 is a method used by some lenders to calculate the amount of interest charged on a loan. The primary objective of using this method is to front-load interest payments, meaning that a majority of the interest due over the life of the loan is paid off within the first few months or years. The method gets its name from the sum of the digits 1 through 12 (the number of months in a year), which adds up to 78.This method allows lenders to recoup a larger share of the interest early in the loan term, which reduces their risk if the loan is paid off or defaulted on early. Although the Rule of 78 helps to protect the financial interests of lenders, it can be disadvantageous to borrowers who wish to pay off their loan ahead of schedule. In general, this financial practice is less common today, but it can still be found in certain types of loans such as car financing or subprime lending.

Examples

The Rule of 78 is a method used by some lenders to calculate interest on loans. This method often leads to higher interest charges in the early life of a loan, which means that it favors the lender over the borrower. As a result, it has become less common and is even illegal for certain types of loans in many countries. However, it is still used in some circumstances. Here are three real-world examples of where you might encounter the Rule of 78:1. Car LoansIn some cases, auto lenders may use the Rule of 78 to calculate prepayment penalties if you pay off your loan early. This means that if you try to pay off your car loan early, you may end up paying nearly the same amount of interest as if you had stuck with the original payment schedule, making early payoff less beneficial for the borrower.2. Second Mortgages and Home Equity LoansSome lenders might use the rule of 78s method for calculating interest on second mortgages or home equity loans. However, it’s important to note that this method of calculating interest is mostly phased out for this kind of loans due to regulatory restrictions.3. Personal LoansCertain personal loan contracts might use the Rule of 78. Like the car loans example, this means that if a borrower chooses to repay their personal loan before its term ends, they could face prepayment penalties, making early repayment less financially advantageous. It’s important to read and understand the terms of any loan agreement before accepting the loan, specifically to look for whether the Rule of 78 is being used to calculate interest.

Frequently Asked Questions(FAQ)

What is the Rule of 78?

The Rule of 78 is a method used in some lending scenarios to allocate pre-calculated interest charges for the life of a loan term. It is a procedure mostly used in short term loans which frontloads your interest payments.

How does the Rule of 78 work?

In the Rule of 78, the lender calculates the total interest over the life of the loan and aggregates it upfront. It then uses the Rule of 78 to determine how much of the early repayments go towards interest versus the loan principal. In essence, the Rule of 78 means that more of the interest is paid off at the beginning of the loan term, less at the end.

What is the significance of the number 78 in the Rule of 78?

The number 78 comes from the sum of the digits 1 through 12, representing a year’s worth of months. The lender assigns this sum to the life of the loan to determine how much of the repayment goes towards paying off interest.

Is the Rule of 78 legal?

As of 1992, the use of the Rule of 78 has been prohibited in loans with terms exceeding 61 months by the Federal Trade Commission. Furthermore, several states have enacted laws prohibiting or limiting its use in shorter-term loans.

When is the Rule of 78 used?

The Rule of 78 tends to be used mostly in short-term loans and particularly for certain auto loans or consumer loans. It’s less common in long-term loans.

Why should consumers be wary of the Rule of 78?

Consumers should be wary because, with the Rule of 78, early repayments include a greater proportion of interest and less principal. This means that even after making regular payments, borrowers may find that they haven’t significantly reduced their total debt.

Does the Rule of 78 have any advantages to borrowers?

Generally, the Rule of 78 is advantageous to lenders over borrowers. However, for borrowers who intend to keep the loan for the full term and will not prepay can consider it an acceptable repayment structure.

Related Finance Terms

  • Precomputed Interest
  • Auto Loan Refinancing
  • Depreciation Schedule
  • Amortization
  • Consumer Credit

Sources for More Information


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