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Banker Math: The Rule of 78s

© Dale Hartley

How your lender calculates interest can be as important as the interest rate, if you prepay a loan. Some lenders use the rule of 78s, and that puts you at a disadvantage. The rule of 78s, also called "the sum of the digits" method, gets its name because the sum of the digits 1 through 12 (the number of months in a one-year loan) is 78.

Under the rule of 78s, interest is accelerated as follows: You pay 12/78 of the total interest in your first month's payment, 11/78 in your second month, and so on until your last payment contains an interest payment of only 1/78 of the total interest due.

For ease of illustration, the above example assumes a one-year loan. But the rule of 78s is most often encountered in car loans, where the term is much longer. On a 48-month car loan, for example, the sum of the digits 1 through 48 is 1176, so your first payment would be 48/1176 and your last payment 1/1176 of the total interest due.

Because the rule of 78s favors the lender if you prepay, critics say it contains a hidden prepayment penalty. In fact, credit expert Andrew Feinberg reports the method is so unfair to consumers that it's outlawed in 17 states.

Over the entire loan term, the calculation won't affect the total finance charge. But if you pay off your loan early, you'll pay more under the rule of the 78s; the lender retains interest you already paid in excess of "simple" interest. The National Consumer Law Center says if you have a $10,000, 10-year loan at 12% and prepay it at the wrong time, you could lose $384.

Because the rule of 78s assigns more interest to early payment, it even can result in negative amortization - a predicament in which your monthly payment is insufficient to pay down the loan balance within the term of the loan.

The Truth in Lending Act doesn't require a lender to disclose how it calculates interest on closed-end loans (non-revolving credit). But look for a tip-off in the Truth in Lending disclosure. If you see a phrase similar to "you will not be entitled to any rebate or part of the finance charge if you prepay," ask if the interest is computed using the rule of 78s.

The best way to avoid the rule of 78s is to shop around for credit. Ask the lender up front if their loans are based on

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