Understanding the Rule of 78s: Simplifying Loan Interests and Prepayments
What is the Rule of 78s?
The Rule of 78s is an accounting method commonly used to calculate the amount of unearned interest on short-term installment loans with add-on interest. This method is widely adopted because it provides a structured way to determine how much interest can be refunded when a borrower decides to pay off the loan early.
Why the Number 78?
The name ‘Rule of 78s’ arises from the sum of the digits from 1 to 12, which is 78. This period represents a standard loan term of 12 months. By adding these digits, the Rule of 78s distributes the interest payments across the loan’s lifespan in a recalculable format. This ensures that the interest is front-loaded, meaning more interest is paid in the initial months than in the later ones.
Detailed Example
Imagine you took out a 12-month installment loan for $1,000 at an 8% add-on interest rate. Let’s break this down:
Initial Loan Setup
- Loan Principal: $1,000
- Add-On Interest: 8%
The total interest over the 12 months would be approximately $80 ($1,000 imes 8%). Adding this interest to the principal results in a total payment of $1,080.
Monthly Payments
Since this is to be paid off over 12 months, the monthly payment would be:
- Monthly Payment: $1,080 / 12 = $90
Unearned Interest Calculation
Under the Rule of 78s, more interest is front-loaded, meaning you pay more interest in the early months. Here’s a simplified breakdown of the interest if prepayment occurs;
- First Month: If you prepay the loan at the end of the first month, you owe one full month’s installment, meaning you’re charged more interest.
For example:
- Total Interest Initially Calculated: $80
- Approximated Interest Paid After One Month: $14
Now, if you decide to pay off the balance at the end of the second month, slightly more than today’s payments include higher unearned interest, crossing over to reduce the refunded interest for upcoming months to approximately 7/78.
Scenarios
- Prepayment at the 1st Month’s End: $80 interest due
- Prepayment at the 2nd Month’s End: Reduced from exceeding paid at 1st milestone due more exceeding paid
- Prepayment by the 11th Month: Majority interest have been paid, approximate refunds smaller
In essence, the Rule of 78s, eventually front-loads interest with higher pay but lowering balance refunds near the closings.
FAQs
Q: Is the Rule of 78s still valid?
A: The Rule of 78s application heavily reduces for lending regulations on ambient credit calculation terms onwards balances tangent refinance and term loans versions.
Q: Can consumers opt-out of ref calculations – Rule of 78 Loans now?
A: Refis individuals options voluntary revisions mutual.Observer consulting available on configurations.
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Related Terms: Unearned interest, Amortization schedule, Smart prepayment.
