Rule of 78
A common question asked about fixed rate, fixed term loans is how the interest and capital is applied. This is done by a system known as the Rule of 78. Let me explain.
Take a standard small business loan, the interest rate is fixed and the term is fixed, the monthly repayments are the same every month for the full term of the borrowing. At the outset you are paying more interest and less capital, then as the loan progresses you gradually start to repay more of the loan and the interest element reduces.
This is why if you settle a loan early it can look unnecessarily expensive. Remember also that many lenders will charge a month of interest as an early repayment charge which can make early settlement even less attractive.
How Rule of 78 Works
Let me use a simple example of;
- Fixed rate, fixed term small business loan
- Loan term is one year
Each month throughout this year the loan repayments are identical. This is how interest and capital is split each month;
- The total interest is calculated
- This total is then divided into 78 parts
- In month one you pay 12 parts of the interest and the rest of the payment is reducing the capital
- In month two you pay 11 parts etc
- In month twelve you pay 1 part interest and the rest is capital
In this way the amount of capital you pay off each month is greater as the term proceeds. 78 being the numbers 1-12 added together. For a two year term loan then 78 becomes 300 etc.
Calculating Rule of 78
There are plenty of excel spreadsheets that calculate the monthly split between capital and interest. If you want to do things easier then this site has a decent tool. Use the ‘total finance charge’ option as it translates better with UK application of Rule of 78. Remember to check for any early repayment charges also.
For any questions about how this works or for any other commercial finance question then please get in touch on 01293 541333 or 0207 866 2102.
By Dave Farmer