The Rule of 78 is likely to appear in a couple of our posts, so we decided to do a separate post to explain it. There is a little math involved, but it’s very straightforward.
The Rule of 78 (also known as the “sum of the digits”) is often used as the the basis for companies to earn interest on loans, calculate interest rebates, or even calculate car insurance refunds. Understanding how it works and impacts you will assist you in making wise decisions in these matters.
Its name is derived from adding up the number of months in a year, meaning, January is month 1, February is month 2, March is month 3, etc to December is month 12. As a result:
1 + 2 +3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78
How does it work
Let’s use a loan example to illustrate, but first, here are a couple important points:
- The Rule of 78 only applies to add-on loans, or put another way, loans where the total interest is calculated upfront and your instalment is based on total interest plus principal.
- Therefore it does not apply to normal simple interest loans i.e. where interest is computed on the balance outstanding e.g mortgages
(Read our post APR – The True Cost of a Loan to learn more about these loan types.)
For example, a $5,000 add-on loan for 1 year at 10% will mean, $500 total interest; consequently, your monthly instalment is ($5,000 + $500 =) $5,500 / 12 = $458.33.
On the Rule of 78 basis, the lender earns interest (or the flip side, you pay interest) by working in reverse order of the number of months i.e. January is assigned a value of 12, February is assigned a value of 11, etc and December is assigned a value of 1. Each value assigned is then divided by 78 and multiplied by the total interest due.
So, in January, 12/78 x 500 = $76.92 is earned (or the flip side is you paid this amount in interest).
in February, 11/78 x 500 = $70.51 is earned (or you paid).
Hopefully, you’ll agree this is not too difficult, but you’re probably wondering why this matters. There are two points to note:
- Firstly, interest is not spread evenly over the payments during the term of the loan. Instead in the early period of your loan, more of your instalment is allocated to paying interest than principal.
If you use the example provided, you’ll see three-quarters of the loan’s interest was earned in the first half of the loan term. This means the loan is MORE EXPENSIVE compared to other loan types at the same point in the loan
- Secondly, if the Rule of 78 is used to calculate refunds and rebates, the longer you wait to early repay, the lower rebate you will receive.
In the post Understanding Hire Purchase – Part 2, we covered the topic of interest rebates when you decide to early repay your loan. Once you have passed the halfway point of a HP loan that uses the Rule of 78, it really does not make much sense to consider early repayment, as you will not save much interest from this date.
This means, if you are planning to repay a loan early, add-on loans are not the best choice. You should search for an alternative loan type.
We hope you found the post helpful and now understand a bit better how these all interact and contribute to the cost of your loan:
- Loan type (add-on or simple interest),
- The application of the Rule of 78,
- The loan’s effective APR
If you have questions or experiences to share, we’d love to hear from you in the comments below!