The Rule of 78
For anyone who has taken, or looking to take out a fixed rate, fixed period loan then the Rule of 78 is something you would do well to understand.
The basic concept behind the Rule of 78 is about how interest is calculated on an annual basis, this determines how much of your monthly payment is interest and how much is capital.
What this means is that whilst each month you pay the same repayment amount, you pay a greater amount of interest on the early payments than you do at the end of the loan.
How the Rule of 78 Works
The easiest way is to bullet point things;
- The rule is based on one year of interest
- The ’78’ comes from adding the numbers from 1-12 together
- The annual interest is divided into 78 units
- In month one you pay 12 units of interest with the remaining part of your repayment being capital
- In month two you pay 11 units, month three 10 units and so on until in month twelve you only pay 1 unit of interest
Because of this the early repayments are largely just interest and your actual balance of what you owe only reduces very slowly until some way into the loan period. We thought about producing a calculator for you to use, but this one is pretty good and works just as well.
Are All Loans Worked Like This?
No. Take your mortgage. It may be on a fixed or variable rate but how interest is worked is very different. With a mortgage or any ‘daily accrual’ interest loan you will see the interest being added to your loan each month, this works on the following basis;
- Take the balance of your loan
- Times the balance by your annual interest rate
- Divide this figure by 365 then times it by the days in that month
The formula is; ((Balance x Interest Rate) / 365) x days per month
What this means for you is that each month your loan balance is reducing and you will gradually be paying less and less interest. In many ways it is a clearer and easy to understand way of working things out.
Most mortgage loans or commercial loans are worked on this basis.
The Downside to Rule of 78 Loan
Whilst the rule is commonly accepted and applies to CCA regulated fixed rate loans, it does have some downsides if you are not careful. In the main the downsides are;
- If you repay your loan early then you could be penalised
- Most Rule of 78 loans carry a penalty to break them
- If you repay your loan in the very early stages you could end up making repayments and still owing more than you borrowed
As an aside, if you take a loan on this basis where the total period is one year or less, the Consumer Credit (Early Settlement) Regulations 2004 says that the lender cannot charge a penalty. Worth knowing in case you are ever quoted a penalty (in can happen…).
Why Rule of 78 is Important
The biggest misconception of loans is that the borrower thinks they are repaying what they owe quicker than is actually the case. We have also seen borrowers taking out a loan worked on this basis only to try and repay it early and find they owe far more than they thought.
If you plan to repay a loan early then the interest rate on this type of loan becomes much higher in real terms.
All we are saying is to be aware of how your loan is being worked out before signing up.
The second benefit is that it always helps to know a little more. You may well find that with banks having reduced the experience of their front-line staff that it may be you explaining this rule to them instead.
Whilst the Rule of 78 generally applies to personal loans governed by the CCA it does also apply to some Small Business Loans, especially those up to £25k.
For any other business finance or lending queries then please get in touch.
By Dave Farmer
Dave Farmer is founder of the award winning business finance specialist Lime Consultancy.