Old consumer loan method comes back to surprise

An old refinancing wrinkle surfaced recently when a reader brought up an issue that we have not explored for years.

She had purchased a home with the proceeds from her previous home plus a small balance that was financed by the owner. She had planned to pay the small balance off within three years and save some interest money but was shocked to discover the loan structure – “the rule of 78s” – did not allow any savings.

Lenders frequently used the rule of 78s for personal loans and auto loans because it’s quick and simple to apply to a prepaid loan. The rule of 78s is only a problem for someone who decides to pay off a loan before the agreed upon term of the loan. In this case, the owner of the home was a retired car dealer and opted to employ the loan method on the woman’s loan.

When lenders use the rule of 78s, they distribute the total finance charge over all payments but charge more interest early in the loan term and less later compared with other methods such as simple interest. Mortgage interest is also front-loaded but a prepayment penalty is not automatically built into the payment system like it is with the rule of 78s.

The rule of 78s, also called the sum of digits method, gets its name because the sum of digits 1 through 12, the months in a one-year loan, is 78.

Here’s how the rule of 78s works for a 12-month loan: You pay 12/78 of the total finance charge the first month, 11/78 the second month, 10/78 the third month, and so on. The rule of 78s applies the same way for long-term loans. For example, a 24-month loan – where the sum of the digits for months one through 24 is 300 – would have a first month’s interest of 24/300, second month’s interest of 23/300, and 22/300 for the third month. Interest on a 36-month loan would be broken into 666 parts.

In contrast, credit unions traditionally charge simple interest on a declining balance. This method assesses interest only for the period that you use the money. With both loan calculation methods, each monthly payment is part principal and part interest. The rule of 78s assigns more interest to early payments than does the simple interest approach.

Why should you care? It can cost you if you’re thinking about paying off – or refinancing – a rule of 78s loan before it matures. The rule of 78s is a method for refunding unearned interest when an installment loan is paid off before maturity.

A private party probably will not supply you with a Truth in Lending sheet. While there’s only a remote chance you cannot prepay the balance without a penalty, always ask and require the party to discuss the prepayment possibilities.