Rule of 78 - Explained
What is the Rule of 78?
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What is the Rule of 78?
The Rule of 78 is a method of calculating yearly interest which is commonly applied to the short-term consumer and business loans. The name Rule of 78 is derived from the sum of the digits 1 through 12 as a year has 12 months. The rule is also known as the sum-of-the-digits-method. The Rule of 78 method applies more weight to the months in the earlier part of a loan cycle. It earns a greater profit for the lender if a borrower makes an early payment. Rule of 78 is primarily used for calculating yearly interest of fixed-rate, non-revolving loans.
How Does the Rule of 78 Work?
If the borrower pays only the amount which is due each month, this rule won't impact the total amount of the interest paid. If the borrower intends to pay off the loan early this method maximizes the total amount paid by applying funds to interest before principal. Thus, in the U.S. this type of financing is declared illegal for the loans with a duration of more than 61 months. This method is often applied to the short-term loans provided to the subprime borrowers. In this calculation, the lender weights the interest payment in reverse order putting greater weight to the earlier months. If a loan cycle is one year long then the weighting factor would be 12/78 of the total interest in the first month, 11/78 in the second month, 10/78 in the third month and so on. If the loan duration is 2 years the weighting factor would be calculated as 24/300 (300 is the summation of the number of months in two years) for the first month, 23/300 for the second month and so on. This is a much more complex method of calculating the interest than simple annual percentage rate. The amount of interest is the same for both of these types of loans if the borrower pays the exact amount due on each month throughout the loan cycle and does not make any pre-payment. A repayment of loans involves repaying the principal amount and the interest. As the Rule of 78 method weights earlier payments with more interest if the borrower makes early payments, he or she will have to pay slightly more interest in total.