What Is the Rule of 78?

How the Rule of 78 works

The Rule of 78 is a strategy that lenders use tocharge at a higher rate at the beginning of the loan rather than at the end. The payment amount remains constant. But the portion applied to interest decreases while the portion applied to principal increases over time.

The Rule of 78 is named for its calculation, using the sum of the numbers 1 through 12 for a one-year loan:

1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78.

This means that for the first month of the loan, you will pay 12/78 of the precomputed interest, 11/78 in the second month, 10/78 in the third month and so on. The final month will include 1/78 of the precomputed interest for your last loan payment.

If you make any extra payments, they are used as prepayment for both the principal and interest coming due in the following months.

Calculating interest using the Rule of 78

The Rule of 78 calculates interest on a sliding scale that charges the most interest upfront. Keep in mind that this calculation only accounts for a one-year loan. If you are considering a two-year loan, the total sum will be 300 and would begin with interest payments of 24/300 for the first month, 23/300 in the second, 22/300 in the third and so on.

“If you are offered a loan using the Rule of 78, ask for the math,” Eric Croak, president at Croak Capital in Toledo, Ohio, advised. He also stressed the need for a review of the amortization schedule. “If you cannot see where your payments go, walk. You are better off with a loan where each payment actually chips away at the balance; otherwise, you are just burning cash.”

Be sure to check the requirements for your personal loan to see if the Rule of 78 applies so you can accurately calculate your monthly interest payments.

How the Rule of 78 affects borrowers

These precomputed interest loans are not so great for borrowers because they do not save as much in interest if they pay off their loan early. However, they are ideal for lenders because they maximize the amount of interest they receive.

“If there’s one old-school math trick borrowers need to know, it’s the Rule of 78,” Croak warned. “It’s skewed on purpose!”

“If the borrower pays the loan in full according to schedule, the total interest paid would be the same as a simple annual percentage rate (APR) loan,” Kuderna said. “If the borrower prepays the loan, they don't save as much.” Therefore, it does not incentivize borrowers to pay off their loans early when they do not reap the usual savings.

Why it’s controversial

If you pay off the loan early, you’ve already paid a big chunk of the interest in the beginning. So, you save far less than with a simple interest method.

“The Rule of 78 is basically a lender’s dream and a borrower’s blind spot,” Croak said. Because of this, this type of loan is largely considered unfair to borrowers and increasingly difficult to find. “It's often used on subprime borrowers, which creates some controversy,” Kuderna explained.

When it applies

The Rule of 78 most often applies to short-term loans and loans for bad credit, especially with personal loans and car loans. This is because it presents a lower risk for lenders since they are paid more interest upfront.

» MORE: Personal loan pros and cons

Rule of 78 vs. simple interest

Unlike the rule of 78, simple interest (also known as the amortizing rate) uses a fixed rate to calculate interest based on your outstanding balance each month. Simple interest is only assessed on the amount borrowed and not on the interest that accumulates. It can be calculated either daily or monthly.

Simple Interest = Principal x Annual Interest Rate x Loan Term (in years)

When a loan uses simple interest, it can save you money on interest. If you pay more than your monthly payment amount, your principal decreases, so you pay less in interest. However, when loans use the Rule of 78, you pay the most interest at the beginning of your loan, so you do not stand to reap the same savings if you pay your loan off early.

Most traditional loans, such as personal loans, car loans and home mortgages, use simple interest, but there are still some lenders that offer loans using the Rule of 78.

Legal status and restrictions of the Rule of 78

The Rule of 78 was a more widespread practice in the past, but in 1992, the U.S. government passed legislation outlawing the Rule of 78 on loans that last longer than 61 months. This still enables lenders to offer short-term loans under the Rule of 78, but most lenders today favor simple interest for their loans.

There may also be additional local restrictions regarding the Rule of 78. Some states may have additional requirements, while others have outlawed it altogether. The Attorney General in your state can provide more information about local laws.