Rule of 78 – Definition

Cite this article as:"Rule of 78 – Definition," in The Business Professor, updated December 11, 2018, last accessed October 21, 2020, https://thebusinessprofessor.com/lesson/rule-of-78-explained/.

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Rule of 78 Definition

The Rule of 78 is a method of calculating yearly interest which is commonly applied to the short-term consumer and business loans. The name “Rule of 78” is derived from the sum of the digits 1 through 12 as a year has 12 months. The rule is also known as the “sum-of-the-digits-method”.

The Rule of 78 method applies more weight to the months in the earlier part of a loan cycle. It earns a greater profit for the lender if a borrower makes an early payment.

Rule of 78 is primarily used for calculating yearly interest of fixed-rate, non-revolving loans.

A Little More on What is the Rule of 78

If the borrower pays only the amount which is due each month, this rule won’t impact the total amount of the interest paid. If the borrower intends to pay off the loan early this method maximizes the total amount paid by applying funds to interest before principal. Thus, in the U.S. this type of financing is declared illegal for the loans with a duration of more than 61 months. This method is often applied to the short-term loans provided to the subprime borrowers.

In this calculation, the lender weights the interest payment in reverse order putting greater weight to the earlier months. If a loan cycle is one year long then the weighting factor would be 12/78 of the total interest in the first month, 11/78 in the second month, 10/78 in the third month and so on. If the loan duration is 2 years the weighting factor would be calculated as 24/300 (300 is the summation of the number of months in two years) for the first month, 23/300 for the second month and so on.

This is a much more complex method of calculating the interest than simple annual percentage rate. The amount of interest is the same for both of these types of loans if the borrower pays the exact amount due on each month throughout the loan cycle and does not make any pre-payment.
A repayment of loans involves repaying the principal amount and the interest. As the Rule of 78 method weights earlier payments with more interest if the borrower makes early payments, he or she will have to pay slightly more interest in total.

References for Rule of 78

https://www.investopedia.com/terms/r/ruleof78.asp
https://en.wikipedia.org/wiki/Rule_of_78s
http://www.businessdictionary.com/definition/rule-of-78.html
https://financial-calculators.com/rule-of-78s

Academic Research on Rule of 78

  • The Rule of 78: Hidden Penalty for Prepayment in Consumer Credit Transactions, Hunt, J. H. (1975). BUL Rev.55, 331. This rule (Rule 78) unlike Rule 72 helps to explain the hidden penalty for prepayment in the consumer credit transactions. This study however also gives the difference between these two rules and when each can be applied.
  • THE “RULE OF 78, Bonker, D. (1976). The Journal of Finance31(3), 877-888. This research paper explains the relevance of Rule 78 and how it can be applied to the issue of economic growth.
  • The Rule of 78: Comments, Nesbit, W. N. (1978). Journal of Consumer Affairs12(1), 183-186. This research paper defined Rule 78 as a major means of allocating interest charges for the life of a loan to the period within the loan. This study explains the usefulness of the electronic spreadsheets and the financial calculators as economic tools that render the calculation of a method which is simple but inaccurate to calculate interest refunds in the case of early repayment of a loan.
  • Rule of 78, Hicks, E. L., Serlin, H. H., & Loewenstein, G. (1966). New York Certified Public Accountant (pre-1986)36(000008), 611. This paper explains the main use and the importance of Rule 78. This study also helps to understand the correlation between this rule with the former rule (Rule 72).
  • The ‘Rule of 78‘Cost Penalty: an Alternative Perspective, Stanton, H. G., & Rickard, J. A. (1989). Journal of Business Finance & Accounting16(2), 255-265. According to scholars, this study explains basically the alternative perspectives of the cost penalty via the ways Rule 78 works and how it can be implemented into the economy of any government.
  • Calculate the profit charge rebatąàccording to Rule of 78 and total financing redemption., eYS ZkggSeeS, Y. This research paper explains in-depth the Rule 78 and the total financing redemption of an economy. This paper also explains how profit charge could be calculated and the ways in which this estimation could be done.
  • Rule of 78: A comparison of loan amortization., Chen, R. (1994). National Public Accountant39(3), 20-22. According to this study, a step-by-step method was explained regarding the way a debt payment schedule can be constructed. Although, several financial institutions does not suggest the unpaid principal balance approach. Hence, the adoption of Rule 78 which is the sum total of the “sum-of the-month’s-digit method. This method is an effective approach in penalizing the borrower that pays off debt before the debt is being matured. The steps taken before the application of the Rile 78 is totally explained in this paper.
  • The Rule of 78’s: Bias Against the Borrower, Dyl, E. A., & Joehnk, M. D. (1976). Journal of Consumer Affairs10(2), 251-254. This paper explains the disagreement between Rule 78 and the borrower. In the course of this study, the differences between rule 78 and the borrower. This paper also explains the reasons for this disagreement between these two factors and they were practically explained.
  • Disclosure of Finance Charges: A Rationale, Jordan, R. L., & Warren, W. D. (1965). Mich. L. Rev.64, 1285. This research thesis explains the Disclosure of financial charges. The financial charges which are the difference between the changes in finances and the Rationale were also disclosed. This paper explains all that has to do with a rationale and the correlation between these charges and Rule 78.
  • The Rule of 78: A Rule That Outlived Its Useful Life, Johnson, A. F. (1988). The Mathematics Teacher81(6), 450-480. This study proposed a question and the question reads that “How much of the total interest should be paid to the lending institution if peradventure a consumer loan is prepaid just before the contract time?” the validity of this rule was demonstrated and established also the method used to answer this question was also established.

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