The rule of ’78 is the product of a most unscrupulous set of individuals more keen on gain than fair play. Of course, such people are not hard to find, so many more such “rules” exist in the business world today. Luckily for the rest of us, many US states and a few countries have outlawed the use of the Rule of ’78. The rule is mainly used by auto lenders and is sometimes only explained (in a comprehensive and meaningful way) to the borrower when that person seeks to end the loan relationship prior to the maturity date. Indeed, the rule of ’78 will not be a problem to the borrower if the loan is serviced to maturity. How does the Rule work? Under a simple pre-computed loan, the debtor is usually able to compute the exact monthly repayment sum easily identifying monthly interest and principal. This is very straightforward and easily understood by the average borrower. Assume the following: Amount borrowed - $78,000 Interest rate (per year) - 12% Period - 24 months The information below is extracted from an amortization table. It shows monthly payment of $3,671.73 per month. The middle column shows monthly interest and the third column shows the principal balance remaining. As the borrower you may be presented with a similar table at the time when the loan documents are finalized and signed and you would be expected to make monthly payment of $3,671.73 until maturity or until you decide to payoff the loan. Payment Amount Monthy Interest Balance Due $3,671.73 $780.00 $75,108.27 $3,671.73 $751.08 $72,187.62 $3,671.73 $721.88 $69,237.77 $3,671.73 $692.38 $66,258.41 $3,671.73 $662.58 $63,249.27 $3,671.73 $632.49 $60,210.03 $3,671.73 $602.10 $57,140.40 $3,671.73 $571.40 $54,040.07 $3,671.73 $540.40 $50,908.74 $3,671.73 $509.09 $47,746.10 $3,671.73 $477.46 $44,551.83 $3,671.73 $445.52 $41,325.61 $3,671.73 $413.26 $38,067.14 $3,671.73 $380.67 $34,776.08 $3,671.73 $347.76 $31,452.11 $3,671.73 $314.52 $28,094.90 $3,671.73 $280.95 $24,704.12 $3,671.73 $247.04 $21,279.43 $3,671.73 $212.79 $17,820.49 $3,671.73 $178.20 $14,326.97 $3,671.73 $143.27 $10,798.51 $3,671.73 $107.99 $7,234.76 $3,671.73 $72.35 $3,635.38 $3,671.73 $36.35 $0.00 You signed the loan agreement and started making your monthly payments. After a few months (eleven months to be exact), you got lucky and came into some cash, so you decided to treat yourself to a vacation (first one in seven years!) and you also decided to payoff the loan. You called the bank and informed the loan officer of your decision, and she/he invited you in to discuss the matter. Based on your calculation (see amortization table), the balance remaining on the loan is $44,551.83 and you have already prepared the check for the financial institution. Before you could pass the check over, the loan officer informed you that the balance due is $44,662.30! This is $110.47 more than you expected. Small change, but if you’re like me (pitifully broke), you may find this extremely burdensome. The difference in the payoff amount arises from the amount of interest (as opposed to principal repayment) included in each monthly payment. When using the Rule of ’78 method, the interest portion in each month’s payment is calculated as follows: 1. Sum the number of months (the digits) for the loan. That is, for 12 months its 1+2+3+4+5+6+7+8+9+10+11+12 equal 78; while for 24 months it’s 300 and so on. 2. Determine (what I like to call) the Interest Factor. This is done by dividing the numbered month by the sum of the number of months. For the first month of a 24-month loan, the interest factor is calculated as 24 / 300, for the second month its 23 / 300, for the third month its 22 / 300 and so on. 3. Multiply the Interest Factor for each month by the total interest over the life of the loan (as calculated using the amortization table). This gives the interest amount for each month of the loan using the Rule of ‘78. The table below shows the different in monthly interest using both the Rule of ’78 and the Amortization table: Months Rule of '78 Interest Amortization Table Interest 1 $809.72 $780.00 2 $775.98 $751.08 3 $742.25 $721.88 4 $708.51 $692.38 5 $674.77 $662.58 6 $641.03 $632.49 7 $607.29 $602.10 8 $573.55 $571.40 9 $539.82 $540.40 10 $506.08 $509.09 11 $472.34 $477.46 12 $472.34 $477.46 13 $404.86 $413.26 14 $371.12 $380.67 15 $337.38 $347.76 16 $303.65 $314.52 17 $269.91 $280.95 18 $236.17 $247.04 19 $202.43 $212.79 20 $168.69 $178.20 21 $134.95 $143.27 22 $101.22 $107.99 23 $67.48 $72.35 24 $33.74 $36.35 As you can see, the interest rate using the Rule of '78 starts out higher than the interest rate from the Amortization table. The gap between the two increases for a while (up to the 9th. month in this example) and then starts to fall as the loan approach maturity. The following table shows the payoff amounts at the end of each month for the loan. Note that the payoff amount calculated using the Rule of ’78 is always greater than the payoff amount calculated using the simple interest approach on the Amortization table. Payoff - Rule of '78 Payoff - Amortization Method $75,137.99 $75,108.27 $72,242.25 $72,187.62 $69,312.76 $69,237.77 $66,349.54 $66,258.41 $63,352.58 $63,249.27 $60,321.88 $60,210.03 $57,257.44 $57,140.40 $54,159.26 $54,040.07 $51,027.35 $50,908.74 $47,861.69 $47,746.10 $44,662.30 $44,551.83 $41,429.17 $41,325.61 $38,162.30 $38,067.14 $34,861.69 $34,776.08 $31,527.35 $31,452.11 $28,159.26 $28,094.90 $24,757.44 $24,704.12 $21,321.88 $21,279.43 $17,852.58 $17,820.49 $14,349.54 $14,326.97 $10,812.76 $10,798.51 $7,242.25 $7,234.76 $3,637.99 $3,635.38 $0.00 $0.00 There are no good reasons for the higher payoff amount that is required if the Rule of ’78 is used. This unfair practice has resulted in a number debtors being forced to pay more than they borrowed and more than the interest rate provided for when closing their loan. It is a penalty for doing something that should ideally be rewarded. Luckily, many legislators have seen the unfairness of this system and have taken action to restrict its use. In the United States, the Rule of ’78 is outlawed for loans five years or less in the following states: Arizona Minnesota Delaware Nebraska Idaho Nevada Iowa New Hampshire Kansas New York Maine Oregon Maryland South Dakota Massachussetts Vermont Michigan -