What is the rule of 78s?

Ever wonder why few people pay off their vehicles early? It is probably because their interest is calculated by the Rule of 78s. When your lender uses this method of calculating interest, you pay less principle during the early months or years of the loan.

When a lender uses the Rule of 78s formula, interest each month is calculated as a fraction of the total interest to be paid. The calculation begins by first adding up the digits that represent the number of months in the loan term. For a one-year loan, the total is 78 (1+2+3+4+5...+12 = 78). The first month's interest would be 12/78 of the total finance charge, the second month's interest would be 11/78 of the total finance charge, and so on. If you paid off a one-year loan in six months using the Rule of 78s, you would pay 57/78, or 73 percent of the total interest (12+11+10+9+8+7 = 57).

The formula works the same for a loan of any length. For a two-year loan, the sum of the year's digits is 300 (1+2+3+4+5...+24 = 300). The first month's interest would be 24/300 of the total finance charge and so on. This is a very popular method of calculating interest on vehicle loans.

Because the Rule of 78s favors the lender if you prepay the loan, financial advisers will tell you that it contains a prepayment penalty. Lenders will argue that they use this method of calculation because an early payoff entitles the lender to some compensation for the buyer paying the debt early because the lender wouldn’t be able to collect the rest of the interest.

If you are thinking about paying off a vehicle early, call the lender and ask how the interest is calculated. You may also want your financial advisor or accountant to determine if you would be better off paying off another debt or saving the money.