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The Rule of 78 Explained

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The Rule of 78 is not as widely known as other financial principles but understanding it can be incredibly valuable for anyone looking to navigate loans, interest rates, and repayment schedules.

What is the Rule of 78?

The Rule of 78, also known as the Sum of the Digits method, is a technique used to calculate the interest charges. It was commonly used in the past for installment loans, such as car loans, personal loans, or retail installment contracts.

The name "Rule of 78" refers to the sum of the digits in the denominators of the months in a year. For example, if you have a 12-month loan, the sum of the digits would be 1+2+3+4+5+6+7+8+9+10+11+12 = 78. Hence the name, Rule of 78.

How Does It Work?

To understand how the Rule of 78 works, consider this hypothetical scenario:

You take out a one-year loan for $1,200, with monthly payments of $100. Using the Rule of 78, you can calculate the amount of interest you would pay if you paid off the loan early.

In this case, since it's a one-year loan, the sum of the digits is 78. If you were to pay off the loan after six months, you'd calculate the prepayment penalty using the remaining months of the loan.

To do this, you would add up the digits of the remaining months (7+8+9+10+11+12 = 57) and divide the number of months you've already paid (6) by the total number of months (12). Then, multiply this fraction by the total interest paid over the life of the loan.

Pros and Cons of the Rule of 78

Like any financial tool, the Rule of 78 has advantages and disadvantages.

Pros:

  • Simple Calculation: The Rule of 78 provides a relatively simple method for calculating prepayment penalties on loans.
  • Predictability: Since the calculation is based on a predetermined formula, borrowers can anticipate the cost of prepaying a loan.
  • If you pay the loan according to the original term, your interest charges would be the same as if the loan were simple interest.

    • Cons:

  • Front-Loading Interest: One of the biggest criticisms of the Rule of 78 is that it front-loads interest, meaning borrowers pay more interest upfront. This can make it more expensive to pay off a loan early.
  • Complexity: While the concept of the Rule of 78 may be straightforward, the calculations can be complex and confusing for borrowers.
  • Because Rule of 78 loans are precomputed, it makes staying compliant when rate adjustments are required, such as in the case of SCRA more difficult.

    • Is the Rule of 78 Still Relevant?

    With changes in lending practices and regulations, the Rule of 78 has become less common in recent years. Many lenders now use more transparent methods for calculating prepayment penalties, such as the actuarial method or the simple interest method.

    However, understanding the Rule of 78 can still be valuable, especially for those with existing loans or contracts that may use this calculation method. By understanding how the Rule of 78 works, borrowers can make more informed decisions about loan repayment and potentially save money in the long run.

    If you'd like to learn more about our loan servicing software or how we can help you, email us at solutions@shawsystems.com. Follow us on LinkedIn for more blog posts.



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