The Rule of 78s is an interest calculation method commonly used for installment loans with add-on interest. This method is most applicable to loans with predefined monthly payments over a stipulated period. It facilitates the computation of unearned interest, especially in cases where the borrower opts for early repayment.
Mechanics of the Rule of 78s
The “78” in the Rule of 78s derives from the sum of the digits from 1 to 12, which represents the number of months in a year (i.e., 1 + 2 + 3 + … + 12 = 78). For different loan terms, the sum changes accordingly.
Calculating Unearned Interest
Key Concept: Unearned Interest
Unearned interest is the portion of the total interest that hasn’t yet been earned by the lender due to early loan repayment.
Example Calculation:
Consider a 12-month loan of $1,000 with an 8% add-on interest rate. The total interest is:
The total payment over 12 months is:
Monthly payment:
Prepayment Scenarios:
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After 1 Month: Unearned Interest: \((12/78) \times 80 = 12.31\)
-
After 2 Months: Unearned Interest: \(\frac{12 + 11}{78} \times 80 = 23/78 \times 80 = 23.59\)
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After 11 Months: Unearned Interest: \((1/78) \times 80 = 1.03\)
Special Considerations
- Legality: Certain jurisdictions have regulations against the Rule of 78s due to its accelerated interest earning, which may not favor the borrower.
- Consumer Impact: Borrowers often pay more interest in the initial months, making early repayment less beneficial.
Applications and Comparisons
Applicability in Different Loans
- Installment Loans: Ideal for loans with fixed monthly payments.
- Precomputed Loans: Suitable for loans with interest calculated upfront.
Comparisons
- Straight-Line Method: Unlike the Rule of 78s, this method allocates interest evenly across the loan term.
- Amortized Loans: Interest in amortized loans diminishes over time, inversely proportional to the principal repayment.
Related Terms
- Add-On Interest: Interest calculated upfront and added to the loan’s principal.
- Amortization: Gradual repayment of a loan through scheduled payments.
- Precomputed Interest: Interest calculated at loan inception and included in the payments.
FAQs
Is the Rule of 78s still used today?
Why is the Rule of 78s considered unfavorable for early repayment?
How does the Rule of 78s affect loan planning?
References
- Federal Reserve Consumer Compliance Handbook.
- Loan Amortization and Installment Loans, Financial Accounting Standards Board.
- “Consumer Lending Theory and Practice,” by David Moylan.
Summary
The Rule of 78s is a specific method used to calculate unearned interest on installment loans with add-on interest. Though its use has diminished due to regulatory constraints and consumer protection awareness, understanding its application remains crucial for financial literacy.
This structured and detailed entry provides a comprehensive overview of the Rule of 78s, ensuring a clear understanding of its use, implications, and the context within which it operates.
