The Rule of 78

When you borrow a sum of money from a bank or other lender, you usually arrange to repay the loan with a fixed interest rate by a specific date in a set number of equal installments. The rule of 78 is one way in which lenders calculate how much interest you should have paid at any stage during the repayment period of a fixed rate installment loan.

Where does “78” come from? The number derives from the 12 monthly parts of a one-year period. The sum of those parts (12+11+10+9+8+7+6+5+4+3+2+1) is 78. Thus, for a loan with a one-year duration, the lender expects you to pay 12/78ths of the interest in month one, 11/78ths in month two and so on down to 1/78th in month twelve.

The rule of 78 takes into consideration the fact that you pay more interest in the beginning of a loan when you have the use of more of the money and you pay less interest as the debt is reduced. Because each repayment installment is the same size, the part going to pay off the amount borrowed increases over time and the part representing interest decreases.

Should you decide to repay a loan early, the lending institution will use the rule of 78 to determine how much interest you do not have to pay. However, you may be unpleasantly surprised by how much of the capital sum of your loan remains outstanding.

The key point is that the interest you are charged on the sum you have borrowed is NOT spread evenly over the number of payments you have agree to make. Thus in the early period of your loan's life span you have been paying more interest and less capital, reducing the outstanding amount more slowly than you may have assumed.

See also: Financial Services