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Rule of 78: Understanding Its Use and Calculation
The Rule of 78, also known as the sum-of-the-digits method, is a technique employed by certn lers to compute interest charges on non-revolving short-term loans or those pd off ahead of schedule. This method favors the ler by concentrating more interest payments in the earlier months of a loan cycle.
The Rule of 78 method emphasizes that a larger portion of the interest must be pd upfront, particularly during the initial phase of repayment, which subsequently reduces potential savings for borrowers who pay off their loans early. This approach is especially relevant for loans with fixed rates and installment payments.
The Rule of 78 differs from a strghtforward Annual Percentage Rate APR calculation in that the total interest pd under both methods would be equivalent if no prepayments are made over the loan's full term. However, the distribution of this interest is handled differently.
In its application, Rule of 78 allocates interest charges disproportionately to earlier months by assigning higher weights to months at the start of the loan cycle. For instance:
For a one-year loan: You add up numbers from 1 to 12 1+2+3...+11+12 = 78.
For a two-year loan: Summarize from 1 to 24 months 1+2+3...+23+24.
Here’s how this might play out:
Example:
If you're considering a one-year loan with the Rule of 78 method, let's break down the first month interest payment. Imagine your total annual interest is $600.
In comparison:
This implies that with Rule of 78, the borrower pays more upfront than they would under a simple interest calculation.
For borrowers ming to pay off their loan early:
In the scenario above, if you were to settle your year-long debt after just twelve months using the Rule of 78 method:
Understanding the Rule of 78, its calculations, and implications can help borrowers make informed choices about loan terms and repayment strategies. While it might seem advantageous at first glance due to the potentially lower monthly payments early on, borrowers should weigh this agnst higher total costs if they plan on paying off their loans before maturity.
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