In a Nutshell
Repaying a loan early can seem like a great way to reduce the amount of interest you pay on the money you’ve borrowed. But the Rule of 78 — a calculation method that’s more than 80 years old — could mean the lender gets to keep more of any interest you’ve already prepaid on your loan.Small differences in interest rates can have a big impact on how much interest you pay over the life of a loan.
And you probably think repaying a loan early will reduce the amount of interest you pay on the money you’ve borrowed. But if your lender uses the Rule of 78 method — also known as the “Sum of the Digits” method — to calculate how much interest to refund to you when you pay off a loan early, you still could end up paying more interest than you expected.
There’s good news, though. Federal law restricts the conditions under which a lender can use the Rule of 78 to calculate an interest refund, and some states prohibit its use altogether.
Let’s look at how interest works, what the Rule of 78 is, where the rule came from and when you might encounter it.
- Loan interest basics
- What is the Rule of 78?
- How Rule of 78 loan interest is calculated
- Rule of 78 vs. simple interest
- When you might encounter the Rule of 78
Loan interest basics
When you repay a loan, a portion of your monthly payments goes toward repaying the principal (the amount you borrowed) and a portion toward interest (the lender’s fee on the money you borrowed).
Lenders can use the simple interest method for calculating your interest payments. With this method, your loan balance starts off with only the principal you borrowed. Interest is calculated based on your loan balance between payment dates. If you repay your loan before the end of the loan term, you’ll pay less in interest.
Or, lenders can follow the Rule of 78, which relies on calculating interest in advance. If your loan interest is calculated beforehand, your balance includes both the principal you borrowed and all the interest you’ll be expected to pay over the life of the loan — assuming you repay it according to the loan terms. Interest charges are calculated according to a preset schedule, and not according to what you actually owe as you repay the loan.
Learn more about loan principalWhat is the Rule of 78?
The Rule of 78 is a method of calculating how much precalculated interest a lender refunds to a borrower who pays off a loan early. This calculation method almost always works in the lender’s favor, allowing them to keep more money in their pockets when refunding loan interest.
The Rule of 78 is designed so that borrowers pay the same interest charges over the life of a loan as they would with a loan that uses the simple interest method. But because of some mathematical quirks, you end up paying a greater share of the interest upfront. That means if you pay off the loan early, you’ll end up paying more overall for a Rule of 78 loan compared with a simple-interest loan.
Origins of the Rule of 78
The Rule of 78 dates to the Great Depression era, when people generally took out small loans with low interest rates and short terms. Just like today, sometimes people paid off their loans early and didn’t expect to pay the full amount of interest charges. Lenders, on the other hand, wanted borrowers to pay the full amount of precalculated interest.
In 1935, the Indiana state legislature ruled that people who pay off their loans early don’t need to pay the full amount of interest. The formula contained in this law was the Rule of 78.
How Rule of 78 loan interest is calculated
So how do Rule of 78 calculations work?
First, you add up all the digits for the number of months in the loan. For a 12-month loan, that number is 78 (1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78). Next, you reverse the order of the number of months. So, the first month of the loan would be assigned the number 12 (for the last month of the year), then the second month would be assigned the number 11 (for the 11th month of the year), and so on.
Then, you divide that assigned number (which would be 12 for the first month of the loan, for example) by 78 to calculate what percentage of the total interest you’d pay in that month. Finally, to calculate what that monthly interest charge is, you multiply that percentage by the total interest charge over the life of the loan to see how much interest is paid in that month alone.
Here’s an example using a loan with a $500 interest charge over the life of the loan.
| Month | Numerator | Denominator | Percentage of total interest | Monthly interest |
|---|---|---|---|---|
| 1 | 12 | 78 | 15.4% | $77.00 |
| 2 | 11 | 78 | 14.1% | $70.50 |
| 3 | 10 | 78 | 12.8% | $64.00 |
| 4 | 9 | 78 | 11.5% | $57.50 |
| 5 | 8 | 78 | 10.3% | $51.50 |
| 6 | 7 | 78 | 9.0% | $45.00 |
| 7 | 6 | 78 | 7.7% | $38.50 |
| 8 | 5 | 78 | 6.4% | $32.00 |
| 9 | 4 | 78 | 5.1% | $25.50 |
| 10 | 3 | 78 | 3.8% | $19.00 |
| 11 | 2 | 78 | 2.6% | $13.00 |
| 12 | 1 | 78 | 1.3% | $6.50 |
| Total | 100% | $500.00 |
Rule of 78 vs. simple interest
When you pay off a loan early, federal law requires a lender to refund to you any unearned portion of interest that you paid.
If a lender uses the Rule of 78 to calculate how much to refund you, they can actually keep more of your prepaid interest than if they used the more common simple interest method of calculation.
Here’s an example.
Let’s say you need to take out a 12-month loan in January for $6,000 to pay for home repairs. If the interest rate on that loan is 5%, you’ll have to pay almost $164 in interest over the course of the year, regardless of whether the lender uses the Rule of 78 method or the simple interest method.
| Month | Interest payment Rule of 78 method | Interest payment Simple interest method | Difference |
|---|---|---|---|
| January | $25.18 | $25.00 | $0.18 |
| February | $23.08 | $22.96 | $0.12 |
| March | $20.98 | $20.92 | $0.06 |
| April | $18.89 | $18.87 | $0.02 |
| May | $16.79 | $16.80 | -$0.01 |
| June | $14.69 | $14.73 | -$0.04 |
| July | $12.59 | $12.66 | -$0.07 |
| August | $10.49 | $10.57 | -$0.08 |
| September | $8.39 | $8.47 | -$0.08 |
| October | $6.30 | $6.37 | -$0.07 |
| November | $4.20 | $4.25 | -$0.05 |
| December | $2.10 | $2.13 | -$0.03 |
You can see from this example that while the difference isn’t huge, the earlier interest payments calculated using the Rule of 78 loan are higher than those calculated using the simple interest loan. If you were to pay off your loan in March, for example, you’ll have paid 36 cents more ($0.18 + $0.12 + $0.06 = $0.36) to the lender with the Rule of 78 loan versus the simple interest loan.
For the most part, these differences are small. But the longer the loan term extends and the higher the interest rate, the bigger the difference you’ll see between the two methods.
When you might encounter the Rule of 78
Although the Rule of 78 allows lenders to keep more prepaid interest — even when a borrower pays off a loan early — they can’t use this on a whim. There are rules governing when a lender can apply the Rule of 78.
Federal law generally stipulates that in some cases — like mortgage refinances and other types of consumer loans with precalculated interest — lenders can’t apply the Rule of 78 to loans with repayment periods of longer than 61 months.
Some states prohibit use of the Rule of 78, while others allow lenders to apply it to loans shorter than 61 months.
Bottom line
If your loan is for longer than 61 months — or shorter, but you don’t plan to pay it off early — you may not need to worry about the Rule of 78.
But if your loan is for a shorter term (personal loans can be) or you plan to repay it early, it’s important to understand how your interest is calculated — using either the simple interest or precalculated method. If your loan has precalculated interest and you pay it off early, you could wind up getting less of your prepaid interest refunded.
With any loan product, it’s essential to do your homework before signing on the dotted line. Be sure you’re working with a reputable lender and that you understand all the loan terms, including what happens if you pay off the loan early.