How Banks Fooled You with the Rule of 78

Updated 06 Oct 2016 – By Loanstreet


The Rule of 78 is one of the most prevalent secrets in the banking industry that is barely understood by the public. Without your knowledge, you may have already been subject to this insidious practice and came out on the losing end. What is this sophisticated sounding concept and how does it affect you? Here, we shed light on this practice.

The Rule of 78 is also known as the Sum of Digits method. It is a method for calculating interest that ensures maximum interest is paid at the start of the loan, minimizing any savings from early settlement of loans for borrowers. This practice is commonly applicable to both personal loans and car loans.

How Banks Fooled You with the Rule of 78

What Everybody Thinks

When taking such a loan, the [Total Interest Payable] across the life of the loan is first pre-computed just as you would using the simple interest method (which in itself, is already less fair than the reducing balance method). This is called the cost of financing.

Intuitively, since it is based on the simple interest, the cost of financing would be spread evenly among every instalment, right?

Wrong. And this is where the Rule of 78 happens.

How It Actually Works

Instead of spreading the cost of financing evenly across instalments, banks quietly apportion the majority of the interest to the start of the loan. They determine the interest for the month using this formula:

How Banks Fooled You with the Rule of 78- formula

Looks complicated? Don’t worry. Here it is step by step guide. We use a 1 year personal loan with RM50,000 and interest rate of 10% p.a. as an example:

  1. First the [Total Interest Payable] is calculated using the simple interest formula

  2. Given [N] as the total number of instalments, each instalment is enumerated from 1 to [N]

    • E.g. For a 1 year loan personal loan, the instalments will be numbered 1 to 12

  3. The [Sum of No. of Instalments] is simply 1 + 2 + 3… + [N]

    • E.g. 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78 (Hence, Rule of 78!)

  4. For each progressive month, using the formula given above, the result is that a decreasing fraction of the [Total Interest Payable] becomes payable

    • Interest Payable for Month 1 = 12/78 * [Total Interest Payable]

    • Interest Payable for Month 2 = 11/78 * [Total Interest Payable]

    • Interest Payable for Month 12 = 1/78 * [Total Interest Payable]

Here is what it looks like compared side by side against other interest calculation methods:

How Banks Fooled You with the Rule of 78- table 1

It’s interesting to note that if you keep to the original repayment schedule of the loan, the Rule of 78 would not affect you. But had you decided to settle the loan earlier, banks would already have gotten you to pay 73% of the Total Interest Payable by Month 6!

Should I Settle my Car Loan and Personal Loan Early?

Incredibly, having the public think only of “rebates” and “discounts” for early settlement of personal loans and car loans is among the most successful marketing stunts ever pulled by the banking industry. As a result, most people never understand how the Rule of 78 works against them.

That is not to say to never settle your loans early. It really does make more financial sense sometimes. But the only way to know for sure is to calculate for yourself just how much money you actually will be saving (or losing) by settling a loan early.

The good news is that we’ve created just such a user-friendly tool to do that for you! Use our Car Loan / Personal Loan Settlement Calculator and find out for yourself!

 

 

Continue reading...