If you’re signing a loan agreement and you see language referring to a “rebate of the finance charge”, look closely because that loan might be based on the Rule of 78s. While these front-loaded loans were outlawed in 1992 for terms greater than 61 months, you can still run into them on shorter-termed loans. Long story short, understanding the Rule of 78s will help you avoid loans with hidden prepayment penalties.
How It Works
Calculated to ensure lenders harvest most of their interest payments at the beginning of a loan period, the Rule of 78s inhibits the ability of a borrower to reap the full benefits of paying a loan off early.
This is because most of a debtor’s monthly payment is given over to interest in the initial months of the loan. While the borrower would ultimately pay the same amount of interest if the loan were allowed to run to term, the lender can use this strategy to maximize their profit if the loan is paid off early.
Calculating the Rule of 78s
Let’s focus on a 12-month loan to make the math easy.
The lender adds up the number of months comprising the term of the loan—in this case it would be 1+2+3…10+11+12) which totals 78—thus the name of the strategy. If the loan had a two-year term, it would add up to 300 and so on.
Under this algorithm, the borrower pays 12/78 of the total interest amount in the first month. In other words, 12/78 of the payment would go to interest and 66/78 would go to repaying the principal. This continues in a descending fashion until the last month—at which 1/78 of the payment would cover interest and 77/78 would go to principal.
The percentage of the payment given over to interest remains the same regardless of which payment you’re on with a simple interest loan. In other words, 1/12 of the payment goes to interest each month and 11/12 goes to satisfying the principal.
If you make payments on a simple interest loan for two months, then pay it off in full on the third month, you’ll be on the hook for the remaining amount of the principal still due and you’ll have paid 25 percent of the total interest on the loan.
Meanwhile, with the rule of 78s, you will have paid over 55 percent of the interest during the same period and the remaining balance of the principal will be significantly larger.
As you can see, understanding the Rule of 78s is key to paying less for a loan.
The scheme is set up so lenders make as much money on the loan as possible, regardless of how long you allow the loan to run. Lenders catering to people who fall into the subprime category routinely employ this practice to make sure they get as much profit as possible, without imposing a prepayment penalty—technically.
By the way, if your circumstances find you in this category, you’ll benefit from a consultation with a company like Freedom Debt Relief to explore some ways you can get your finances back on track.
The Bottom Line?
Martin Nunes, an attorney writing for Financial Calculators.com sums the Rule of 78s scheme up thusly;
“While paying a loan off at different times for different maturities and different interest rates produces differing penalty sizes, two general rules of thumb can be still be deduced:
- The higher the interest rate, the greater the penalty amount.
- The earlier the prepayment in relation to the term, the greater the penalty amount.”
In other words, any advantage you could realize from paying the loan off early will be significantly diminished under the Rule of 78s.
And that, my friend, is a prepayment penalty—plain and simple.