Rule of 78
Candlefocus EditorEssentially, the Rule of 78 is designed to provide a more favorable way for the lender to compute interest cost from a loan that is shorter than the full loan term. By putting more of the interest payment burden on the early payments and less on the later payments, the Rule of 78 ensures that the lender receives some degree of return even if the borrower pays off the loan ahead of schedule.
The Rule of 78 is an arithmetic formula, where the sum of the number of payments in the schedule multiplied by the interest rate is equal to the aggregate finance charge. It is often used by lenders when a loan is paid off early, to determine how much of the total finance charge they can keep. The Rule of 78 starts with the calculation of the total finance charge. The total finance charge is based on the principal amount of the loan and the interest rate. From this calculation, the lender then deducts the finance charge for each payment in the loan schedule, starting with the last payment and working back to the first payment. The result of these deductions is the amount of the finance charge that the lender keeps as an additional profit when the loan is paid off early.
The Rule of 78 may be attractive to lenders because it ensures that they receive some payment from loans that are paid off early. By providing this option, the lender is able to protect their profit in the event of loan default or an early payoff. It is, however, important to note that the Rule of 78 is not beneficial for the borrower, as they are still responsible for the full finance charge even if the loan is paid off early.
In summary, the Rule of 78 is an accelerated amortization method used by some lenders to calculate loan interest costs. This formula heavily favors the lender, allowing them to retain a greater portion of the finance cost if the loan is paid off early. While this may make it appealing to a certain segment of lenders, it can be quite costly for the borrowers in the form of higher interest costs.