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The Rule of 78

The Rule of 78
Lauren Ward
Lauren WardUpdated January 17, 2023
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The Rule of 78 is a strategy some lenders use to determine how much interest borrowers pay each month on a loan. With this method, more interest is charged at the beginning of the loan than at the end. That means if a borrower pays off their loan early, they don’t save as much money as they potentially could have, and the lender maximizes their profits. Federal legislation prohibits the Rule of 78 for loans longer than 61 months. In addition, some states have banned the rule completely or placed extra restrictions on it. However, in some places and situations, the rule is still in use, so it’s wise to be aware of it.Here’s what you need to know about the Rule of 78 and how it’s calculated. 

What Is the Rule of 78?

The Rule of 78 is a method that allocates more interest to earlier loan payments. It benefits lenders and is typically seen as unfair to borrowers.Borrowers who pay the exact amount due each month for the full term of the loan won’t end up paying more in interest with the Rule of 78. However, those planning on paying off a personal loan early typically won’t save as much as they could have because they’ll pay a greater portion of interest at the beginning of the loan. In other words, there may be little benefit to repaying the loan ahead of time.It’s called the Rule of 78 because 78 is the sum of the numbers 1 through 12 in a one- year loan term:1+2+3+4+5+6+7+8+9+10+11+12= 78Recommended: 12 Types of Personal Loans: Pros & Cons of Each

How Does the Rule of 78 Work?

Rule of 78 loans are precomputed interest loans. That means the lender precomputes the amount of interest you’ll pay over the full loan term. Then, to figure out what you’ll pay each month, they calculate that amount of interest as a fraction of 78, starting with 12 and then going down to 11, 10, and so on. The first month of your loan, you would pay 12/78 of the total precomputed interest, and in the second month, you’d pay 11/78. In the final month of the loan, you’d pay 1/78 of the interest.The same method is used for longer loans. For example, in the case of a two-year or 24-month loan, your first monthly payment would be 24/300 (300 being the sum of all digits between 1 and 24). 

What Is the Rule of 78 Used For?

The Rule of 78 is used by some lenders. By front-loading interest onto the early loan payments, they maximize their profits.There isn’t necessarily a specific type of loan that the Rule of 78 is used for. However, if you have bad credit, you may want to keep an eye out for the Rule of 78 when you’re taking out a loan. The Rule of 78 has been used for subprime personal loans and subprime auto loans, for instance. If you’re exploring loan options and terms, it’s also wise to understand APR vs interest rate to help get the best possible deal you can.

Is the Rule of 78 Legal?

Since 1992, the Rule of 78 has been prohibited on loans longer than 61 months. In addition, some states prohibit its use altogether. However, this is not the case nationwide. Some loans with terms shorter than 61 months still use the Rule of 78. 

How Interest Is Calculated Using the Rule of 78

For a one-year loan with a total of $2,000 in interest charges, here’s what a lender would charge in interest each month using the Rule of 78:
Month of Loan TermFraction of Interest ChargedMonthly Interest You’ll Pay
While the amount the borrower pays in interest decreases each month, if they were to pay off the loan early, with the Rule of 78 they will have generally paid more in interest than they would have otherwise. Recommended: Predatory Lending: What Is It? How Can You Avoid It?

Rule of 78 vs Simple Interest

A simple interest loan is more common than a Rule of 78 loan. Simple interest loans apply the same interest rate to the balance of your loan principal each month. As your balance goes down, so will the amount of interest you owe. The difference is that, unlike loans that use the Rule of 78, you won’t have to pay a heavily weighted amount of interest at the beginning of the loan. So if you repay your simple interest loan before its loan maturity date, you’ll typically pay less in interest charges overall.

Is the Rule of 78 Bad for Loanees?

The Rule of 78 does not affect borrowers who make their monthly payments over the full term of the loan. But borrowers planning to pay off their loan early will not potentially save as much in interest as they would with a simple interest loan. The Rule of 78 may give borrowers less incentive to pay off their loan early.

The Takeaway

The Rule of 78 is a method that some lenders use to ensure they make a profit if a loan is paid off early. With this practice, interest payments at the beginning of a loan are higher than payments at the end. Borrowers who pay off their loans early typically won’t save as much as they could have. Carefully read the details of any loan agreement before you sign it, so you understand how the interest is calculated and applied.Shopping for personal loan terms and rates can help you find the best loan option for your needs. Lantern makes the process easy and convenient. By filling out one application, you can compare offers from multiple lenders at once.Compare personal loan rates and terms with Lantern.

Frequently Asked Questions

What is the rule of 78?
How does the rule of 78 work?
Is the rule of 78 legal?
Photo credit: iStock/FG Trade

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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