The Rule of 78 for Loans: What It Is and How to Calculate It

The Rule of 78 can be used by lenders to calculate interest that could significantly impact how much you end up paying over the life of a loan. Unlike the standard amortization method, the Rule of 78 front-loads interest payments, meaning borrowers pay more interest in the early months of the loan term. This can be particularly important for those considering early repayment, as it may result in less savings than anticipated.

If you’re considering a loan, a financial advisor can help you compare borrowing options, repayment strategies and minimize interest costs based on your finances.

What Is the Rule of 78?

The Rule of 78 is a method used to calculate interest on certain types of loans, particularly those with fixed terms, such as auto loans or personal loans. The method is also known as the sum-of-the-digits method.

Notably, this approach front-loads interest payments, meaning borrowers pay more interest in the early stages of the loan term. This can be beneficial for lenders, as they receive a larger portion of the interest upfront, but it may not be as advantageous for borrowers who plan to pay off loans early.

The name comes from the sum of the digits of the months in a year, as in 1+2+3+4+5+6+7+8+9+10+11+12=78. The resulting sum is used to allocate interest payments over the loan’s term.

To do this, each month’s interest is calculated by dividing the number of remaining months by 78. For example, in the first month of a 12-month loan, 12/78 of the total interest is due, while in the last month, only 1/78 is due. Notice that this results in higher interest payments at the beginning of the loan term.

For example, a $10,000 loan with a 12% annual interest rate over a one-year term would cost $1,200 in interest. Under the Rule of 78, the first month you would pay 12/78 of the total interest or about $184.62. The last payment would only have 1/78 of the total interest, or about $15.38. If you pay off the loan after six months, you have paid about 57.7% of the total interest, or $692.40, instead of the 50%, or $600, you might expect with simple interest.

For borrowers, the Rule of 78 can have significant financial implications, especially if they intend to pay off their loan early. Since more interest is paid at the beginning of the loan, early repayment does not result in as much interest savings as it would with a simple interest loan.

In some regions, the use of the Rule of 78 has been restricted or banned for certain types of loans due to its potential to disadvantage borrowers. For example, in the United States, the Rule of 78 cannot be used for loans longer than 61 months. This regulation aims to protect consumers from paying disproportionately high interest if they decide to pay off their loans early.

How the Rule of 78 Is Calculated

The Rule of 78 is particularly used on loans with precomputed interest. This method is often applied to short-term loans, such as auto loans, where the borrower pays a fixed monthly amount.

For example, in a 12-month loan, each month’s interest is weighted differently. The first month’s interest is weighted by 12, the second by 11, and so on, until the last month, which is weighted by 1.

This means that the borrower pays a larger portion of the total interest in the initial months. The method benefits lenders if a borrower pays off the loan early, as more interest has already been paid.

Rule of 78 vs. Simple Interest

Simple interest is calculated on the principal amount of a loan or deposit. Unlike the Rule of 78, simple interest does not change over the life of the loan. Borrowers pay interest only on the original principal, making it easier to predict and manage payments.

When comparing the Rule of 78 with simple interest, the primary difference lies in how interest is allocated over the loan term. The Rule of 78 results in higher interest payments at the beginning, which can be a disadvantage for borrowers who refinance or pay off their loans early.

Simple interest, on the other hand, offers a more balanced approach, with interest payments spread evenly throughout the loan term. This can lead to significant savings for borrowers who do not carry the loan to full term.

The choice between the Rule of 78 and simple interest can have a large impact on the total cost of a loan. Borrowers who anticipate the possibility of early repayment should be particularly cautious with loans calculated using the Rule of 78. Simple interest loans can be more cost-effective in such scenarios.

Bottom Line

The Rule of 78 is important to understand if you’re considering a loan with precomputed interest. This method, often used in short-term loans, front-loads interest, so you pay more in the early stages. If you plan to repay the loan early, it can be disadvantageous, as you won’t save as much on interest when compared to loans with simple interest calculations. While it benefits lenders, it generally works against borrowers who expect to pay off their loans early.

Financial Planning Tips

A financial advisor can work with you to manage your debt and loans by creating a repayment plan, reducing interest costs and improving your overall financial health. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you have education debt, SmartAsset’s student loan calculator can help you figure your monthly payments and see how you’ll amortize the loan.
If you plan to buy a home, SmartAsset’s mortgage calculator can help you estimate your monthly mortgage payment with taxes, fees and insurance.