The Rule of 78 is a method of allocating interest throughout the life of a loan. It is also known as sum-of-the-years-digits. The name comes from the way interest is allocated during a one-year loan. The Rule of 78 weights the earlier payments with more interest than the later payments, so twelve parts of the interest are allocated during the first month, eleven parts during the second month, ten parts during the third month, and so forth. During an entire year, there are 12+11+10+…+1 parts allocated or a total of 78 parts. Hence the name “Rule of 78.”
To determine the actual interest allocation, the total interest is divided by 78 and then allocated on a month by month basis as described above.
This is a practice in which lenders amortize repayment of short-term consumer loans in a way that the borrower pays the interest earlier. When paying off a loan, the repayments are composed of two parts: the principal and the interest charged. The Rule of 78 weights the earlier payments with more interest than the later payments. In 12 equal installments, interest is allocated as follows: 12/78 of the interest is considered earned in the first month, 11/78 in the second, 10/78 in the third, and so on. For a two-year loan, the weighting factor would be 24/300 in the first month, 23/300 in the second month, 22/300 in the third month, etc. This methodology is definitely in the best interest of the lender. If the loan is not terminated or prepaid early, the total interest paid between simple interest and the Rule of 78 will be equal. However, paying off a loan early will result in the borrower paying more interest overall.
TValue is an excellent program to handle this calculation and potentially the early payoff amount if needed. In addition to doing a standard Rule of 78 calculation and creating the related amortization schedule, TValue also provides an extension of the Rule of 78 for cases where payments don’t fit the regular pattern just described. In these cases, TValue automatically adjusts the interest allocation in proportion to the balances outstanding and the time that particular balances are outstanding. For example, if a loan is payable in 12 equal monthly installments but payments start two months from the loan date, 24/90 of the interest would be recognized with the first installment, 11/90 in the second, 10/90 in the third, etc.
As you can see this can be a tricky calculation without the proper program. Obviously, loans that are greater than a year or two get even more complex. In 1992, the legislation made this type of financing illegal for loans in the United States with duration of greater than 61 months.
If you have any questions or need any help using TValue software, please give our Support Team a call at 800-426-4741 or email support at support@TimeValue.com.