Some lenders use the Rule of 78 to arrive at the interest portion of a loan payment. The rule of 78 takes the total interest for a loan and apportions excessive interest to the early payments as compared to an amortization schedule.
If the lender uses conventional calculations to arrive at the total interest for the loan but uses the rule of 78 to apportion the total interest cost over the life of the loan then do not take out a lengthy loan and pay it off early. The example below will illustrate the point.
A simple example of $24,000 at 12% with monthly compounding, amortized for two years (24 monthly payments). An annual interest rate of 12% is purposely chosen because most people can do the very first monthly interest calculation in their head. 12% a year with monthly compounding is 1% per month. Thus after one month the interest for $24,000 is $240 (see the green cell below, 1% which is 0.01 thus .01 x $24,000 = $240).
The rule of 78 will use the same total interest of $3,114.32 however it apportions $249.15 to the very first payment. A traditional amortization schedule apportions $240, the correct amount to the first payment.
RULE of 78 Interest allocated over 24 payments is shown below (white background).
If the loan was paid back as $24,000 plus the $3,114.32 over 24 even payments of $1,129.76 there would be no problem. The problem arises when you pay the loan off early as in after 12 months. After 12 months using a conventional amortization schedule, the balance owing after the 12th payment is $12,715.57 and the accumulated interest paid during those 12 months is $2,272.73
Using the rule of 78 method the accumulated interest paid during those 12 months is $2,304.59 which is $31.86 more in interest. The difference becomes more pronounced as the amortization period and the loan amount increases. For example, on a loan of $100,000 amortized for 4 years at 12% with monthly compounding the difference in accumulated interest paid after one year is $564.82 which is no small change.
Scenarios such as this can be avoided by asking for an amortization schedule. Once you look at the breakdown of the very first monthly payment you know where you stand.
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