Rules Of 78s Finance

The Rule of 78s, also known as the “Sum of the Digits” method, was a common, though now largely outdated and criticized, approach to calculating interest refunds on loans that were paid off early. It was frequently used for installment loans, particularly car loans and personal loans, before the widespread adoption of simple interest methods. The fundamental idea behind the Rule of 78s is that it front-loads interest charges, meaning you pay more interest in the early months of the loan and less towards the end.

Here’s how it worked:

1. Calculate the Sum of the Digits: For a 12-month loan, you’d add the numbers 1 through 12 (1+2+3+…+12), which equals 78. This is where the name “Rule of 78s” comes from. For a 24-month loan, you’d sum 1 through 24, resulting in 300. Generally, for an ‘n’ month loan, the sum is calculated as n*(n+1)/2.
2. Determine the Interest to be Paid in a Specific Month: In the first month of a 12-month loan, you’d theoretically pay 12/78ths of the total interest. In the second month, you’d pay 11/78ths, and so on, decreasing by one each month.
3. Calculate the Unearned Interest: If you paid off the loan early, the lender would calculate the amount of unearned interest. This is the amount of interest you haven’t “earned” yet because you’re not using the loan for the originally agreed-upon term. For example, if you paid off a 12-month loan after 6 months, the unearned interest would be the sum of the fractions for months 7 through 12 (6+5+4+3+2+1)/78, or 21/78 of the total interest.
4. Refund the Unearned Interest: The lender would then refund the calculated unearned interest. This refund would reduce the amount you owed to pay off the loan.

Why Was it Used?

The Rule of 78s was administratively simpler for lenders to calculate before the advent of sophisticated computing systems. It provided a consistent, though often less favorable for borrowers, method of calculating rebates.

Criticisms and Decline:

The major drawback of the Rule of 78s is that it significantly benefits lenders and disadvantages borrowers who pay off loans early. Because interest is heavily front-loaded, the unearned interest calculated by the Rule of 78s is usually less than what would be refunded under a simple interest method. This means borrowers often paid a disproportionately large amount of interest even if they only used the loan for a short period. The Rule of 78s was criticized for being opaque and difficult for borrowers to understand. Due to these concerns, many jurisdictions have banned or severely restricted its use. Simple interest calculations are now the standard, offering a more transparent and equitable approach to loan repayment.

While the Rule of 78s is less common today, understanding its principles helps illustrate the evolution of lending practices and the importance of understanding how interest is calculated on your loans. Always inquire about the interest calculation method being used when taking out a loan and compare different loan offers to ensure you are getting the best possible terms.