The Rule of 78s—A Predatory Lender’s Tool

There is an old method of calculating prepayment penalties on pre-computed auto loans (and other types of loans) called the Rule of 78s. Also referred to as the Sum-of-the-digits, both references receive their name from the sum of the digits 1 through 12 (1+2+3+4…, etc., all the way to 12)—the number of months in a single year.

What is the Rule of 78s?

The Rule of 78s was created in the early 1900s as a quick way for lenders to calculate charges to borrowers who paid their loans off early. Today, this method is banned in 17 states, but in the remaining states, it can still be found in installment loan and auto loan contracts.

Rule of 78 car loans are only used on pre-computed car loans.

A pre-computed loan is one in which interest is pre-computed before the loan is agreed to. On pre-computed loans, as soon as borrowers sign a contract they agree to pay the full amount of interest on the loan. Imagine a borrower who obtains a pre-computed five-year loan one day and then wins the lottery the next day. When the borrower tries to pay the loan off (even after borrowing the money for just a single day) he or she will be responsible for five years’ worth of interest.

But lenders coax borrowers into pre-computed loans by saying they will grant the borrower a “rebate” of that owed interest by allowing them to prepay the loan for a fee.

What lenders fail to mention though is that their rebate isn’t so generous when compared to traditional loans, wherein borrowers can typically prepay the loan anytime they’d like for no fee at all.

If a borrower seeks to pay their car loan off when adhering to the Rule of 78s, they are given a “rebate” in exchange for the cost of the number of digits remaining in the car loan’s term divided by the sum of the digits in the car loan’s life. In a one year loan, that sum is 78. If the loan is prepaid after the 2^nd month, the borrower is charged 10/78 (ten months, or digits, remaining over the sum of the months) multiplied by the total amount of interest.

For instance, a Rule of 78s loan for $1,000 with a 12 percent interest rate. That equates to a total of $120 in interest over the course of a year. The first month’s payment would be $88.85, which includes $10 of interest. The next payment will only demand interest on the amount of principal owed—which is now $921.15. The total interest for the second month is only $9.21. But if our borrower prepays his loan on the 2^nd month, they will be charged 10/78 * $120, or $15.39 in a prepayment penalty, otherwise known as a “generous rebate opportunity.”

That brings their total to $1,000 + $10 + $9.21 + $15.39, or $1,034.60.

What an Auto Loan is Supposed to Look Like

Traditional auto loans are computed with simple-interest, meaning interest is accrued only on the principal the borrower is currently borrowing. If a borrower takes out simple-interest financing, they can effectively reduce the interest they will owe by making larger monthly payments and reducing the principal as quickly as possible.

For instance, take the previous example of $1000 and 12 percent interest, but apply that to a simple-interest loan. The first payment would still include the $10 in interest, and the second payment would still include $9.21 in interest. But the difference comes into play when the borrower tries to pay off their simple-interest loan early: there is no penalty.

If the borrower pays their loan off on the second month, they will effectively only be charged a cumulative interest of $19.21, for a grand total of $1019.21.

When obtaining a car loan, particularly from dealerships or “Buy Here Pay Here” lots, borrowers need to make sure it is not a Rule of 78s pre-computed auto loan. If it is, a borrower should politely refuse and seek financing from another source.