What Is The Rule of 78? How Does It Impact Loans?

The rule of 78 is an outdated, uncommon, and complex method of calculating interest on a loan. Most loans, including personal loans, don’t use the rule of 78. Still, it’s a good idea to watch out for the rule of 78 in your loan agreement since it can increase your loan’s cost. Here’s what you need to know.

What is the rule of 78?

The rule of 78 front-loads your loan payments with interest, so that you pay most of it at the start of the loan. Unlike almost all loans issued today, the total interest is calculated at the start of the loan and added to the principal balance — payments made reduce this balance (principal plus interest) over the loan’s term. The portion of each payment going toward interest is largest upfront, which is where “78” comes in.

To help clarify, let’s consider a more typical installment loan. For example, on a personal loan charging simple interest (standard practice), you’d owe interest each month on the loan’s remaining balance — meaning as you make loan payments, the balance reduces and so does the interest you pay. (You only owe interest on the full balance for the first month of the loan.) However, since a loan using the rule of 78 precomputes interest on the full balance and applies that to the loan’s entire term, it costs more. And there may be little benefit in paying it off early.  

This type of interest calculation benefits the lender. If your financial situation changes and you can no longer make payments, you’ll have already covered more of the lender’s cost. The rule is less favorable for the borrower, because they won’t save as much if they repay the loan early. 

How does the rule of 78 impact personal loans?

Fortunately, most lenders don’t use the rule of 78 anymore. Federal law passed in 1992 restricts use of the rule on loans with repayment terms greater than 61 months, requiring that the refund for early repayment be as favorable as the actuarial method.

Most personal loans use the simple interest method and an amortization schedule to equalize payments and spread interest costs across the loan’s term. With an amortized loan charging simple interest, you’ll still pay more interest at the beginning of the loan, but interest decreases each month since you’re paying down the loan’s balance — and new interest charges are calculated based on the new (lower) principal balance. (This all happens even though you pay the same amount every month.) Simple interest and amortization benefit borrowers much more than the rule of 78 and can allow for substantial savings if you pay the loan off early. You can use a personal loan calculator to see how much you’ll save on an amortized loan with early repayment. 

How the rule of 78 works

When a loan uses the rule of 78, the interest is precomputed and added to the loan balance so that the amount of interest decreases while the monthly payment stays the same. But ”paying off early doesn’t reduce interest much [since it’s already been calculated], making these loans more costly overall,” says Christensen.

Step-by-step breakdown

The rule of 78 gets its name from the precomputed monthly interest payments on a one-year loan. If you assigned digits to each month in the year (1 for January, 2 for February, etc.), the numbers would add up to 78. For a one-year loan, the rule of 78 allocates interest charges as follows:

1. In the first month of the loan, you pay 12/78 of the interest. 
2. In the second month, you pay 11/78 of the interest. 
3. Each month, you pay less interest and more principal, until your final payment, which includes just 1/78 of the interest. 

Example loan calculation

For example, if you took out a 12-month, $10,000 loan with a 20% interest rate, you would pay $2,000 over the course of the loan’s term in precomputed interest (20% x $10,000). If the monthly payment is $1,000, it would be split between interest and principal each month as follows. 

Rule of 78 vs simple interest loans

With simple interest loans that are amortized, the monthly interest charge is calculated based on your outstanding balance each month rather than precomputed based on the original amount you borrowed. 

For example, if you took out a $10,000 loan with a 12-month term and a 20% interest rate, the lender would apply a complex calculation to determine your monthly interest charge that can be approximated as follows:

1. The lender divides your interest rate (0.2 as a decimal) by the number of payments (12) to get 0.0166 (0.2/12).
2. Each month, the lender multiplies your outstanding balance by the figure calculated above. For example, you’d pay $166.66 in interest (10,000 x 0.0166) the first month, and the rest of your monthly payment would go toward the principal. 
3. The amount you pay toward the principal reduces your outstanding balance, and the lender uses the same formula to recalculate your interest charge the following month. Your interest payment would decrease each month until you pay off the loan entirely.

In this example, paying simple interest leads to a lower total borrowing cost than the same example using the rule of 78 calculation. Your total interest charge over the life of the loan would be $1,116 — almost $1,000 less than calculating interest using the rule of 78.