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- What Are Netting Escrows & How Does It Work?: The Best Guide - January 2, 2024
- The Secret About Prescriptive Easement: Top Guide 1 Must Know - December 4, 2023
- About Home Equity Loans In Texas And How Can One Obtain It - November 27, 2023
About Rule Of 78
When you take any loan the lender will charge interest on the amount that you have borrowed.
Usually, interest calculation is pretty straightforward. But some lenders may have it calculated differently.
If you are thinking of getting a short-term loan, you should be aware of this term known as the rule of 78. In this post, we will understand what the rule of 78 is and how is it calculated.
What Is The Rule Of 78?
Rule of 78 is a financial calculation method to pre-calculate the interest rate on a loan that favors the lender over the borrower on short-term loans.
Before 1992, the lenders were able to apply this rule for any loans, however, in 1992 the rule was outlawed in the country for any loans more than sixty-one months and several states outlawed it completely.
This rule is used by the lenders on short-term non-revolving loans like auto loans, personal loans, etc.
The lenders use this rule to make a profit on the interest rate early in the loan cycle where the interest amount is weighted higher than the later part of the loan cycle.
How Does The Rule Of 78 Work?
The rule of 78 formula is a little complicated compared to the annual percentage rate that is charged for most of the non-revolving loans. In both types of loans, the interest amount paid by the borrower remains the same it is just that the weight of the interest rate is higher in rule 78.
This rule is applied to the loans with a term period of one year or twelve months. If you add one to twelve months you would get the number 78, hence the name (1+2+3+4+5+6+7+8+9+10+11+12=78).
Once the sum of months is done, the lender will then weigh the interest rates in reverse order to make sure the maximum interest amount is collected from the borrower in the earlier loan cycle.
So the first month’s interest would be calculated as 12/78 of the total interest, for the second month it would be 11/78, the third month 10/78, and so on till the twelfth month where it would be 1/78.
Even if the borrower decides to pre-pay the loan, the lender will still cover most of the interest amount that is charged over the tenure of the loan.
The borrower ends up paying more interest up front in the early payment cycle compared to what he/she would pay otherwise in a simple interest calculation. If you are taking the loan for two years the rule changes from 78 to 300.
As per the Truth In Lending Act, the lender is supposed to disclose if the borrower is entitled to receive any refund in case of an early payoff of the loan. To calculate the refund, there is a specific formula that the lenders use.
(U x (U + 1)) / (T x (T + 1)) = Rule of 78 refund fraction x F = Refund. Where U is remaining term periods, T is term periods, and F is finance charge
For example, if the borrower has taken a 12 month loan there under this rule 78 and has make payment for two months.
This leaves with 10 months of payments and the borrower pre-pays the loan and the lender finance charge is $150. In this case the refund will be calculated in following way. U=10, T=12, F=$150
(10 x (10+1)) / (12 x (12+1)) = (10 x 11) / (12 x 13) = 110 / 156 = 0.705
0.705 x 150 (Finance Charge) = 105.75
In this example, if the borrower pays off the loan after making two payments he will receive a refund of $105.75 from the lender.
Conclusion
If you are planning to get a short-term loan from any lender, you must understand this rule.
It would help you understand how the interest amount is calculated and how much refund you will receive if you decide to pay off your loan early.
You may want to compare the same loan with a simple interest calculation to see the difference in savings on your interest amount if you are planning to pay off your loan early.
