Understanding the Rule of 78

The Rule of 78 is an interest-allocation method used on fixed-rate, non-revolving loans that front-loads interest charges toward the early payments. It benefits lenders and reduces the savings a borrower realizes if they repay the loan early. Borrowers who may prepay should understand how it changes interest allocation and their potential payoff amounts.

Key points

• The Rule of 78 gives larger portions of total interest to earlier months of a loan and smaller portions to later months.
• If a loan is paid in full over its full term, total interest paid equals that of a conventional amortizing loan. If prepaid early, the Rule of 78 typically results in less interest rebate than a simple-interest loan, so borrowers keep paying more interest.
• This method is most common on short-term installment loans and has been restricted or banned in many jurisdictions.
• In the U.S., federal law made the Rule of 78 illegal for loans longer than 61 months; some states have stricter limits.

How the Rule of 78 works

For an n-month loan, the lender sums the integers from 1 to n:
sum = 1 + 2 + … + n = n(n + 1) / 2

Each month is assigned a weight that is proportional to its remaining position in the schedule:
weight for month m = (n − m + 1) / sum

Total interest for the loan is allocated across months according to these weights, so earlier months receive larger shares. Example:
* 12-month loan: sum = 78. Month 1 receives 12/78 of the total interest, month 2 receives 11/78, …, month 12 receives 1/78.
* 24-month loan: sum = 300. Month 1 receives 24/300, etc.

If a borrower prepays after t months, the lender effectively keeps the interest corresponding to the first t weights. The rebate (remaining interest returned to the borrower) is proportional to the sum of the remaining weights:
Rebate fraction = [sum − t(t + 1)/2] / sum
(where sum = n(n + 1)/2)

Comparison with simple interest loans

• Simple interest loans calculate interest on the outstanding principal balance each period; prepayments reduce future interest immediately.
• With the Rule of 78, interest is pre-allocated, so prepayment typically yields a smaller rebate (i.e., the borrower pays more interest) than under simple interest.
• If the loan runs the full term without prepayment, total interest paid is the same under either method.

Example (illustrative):
* Two-year ($10,000) loan at 5% fixed rate: total interest over 24 months is the same under both methods (about $529.13).
* If prepaid after 12 months, the total payoff under simple interest may be slightly lower than under the Rule of 78 (the difference is small for short-term loans but grows with longer terms where allowed).

Legal status and consumer protection

• U.S. federal law (1992) bans the Rule of 78 for loans longer than 61 months.
• Many states have additional restrictions; some ban the method entirely.
• Lenders must disclose loan terms—borrowers should verify whether a loan uses the Rule of 78 and check state laws before signing.

What borrowers should do

• Ask whether the loan uses the Rule of 78 or simple interest and request examples showing payoff amounts at various prepayment points.
• If you expect to prepay or refinance, prefer simple-interest loans or loans without prepayment penalties.
• Consult your state’s consumer protection office or an independent financial advisor if you’re unsure about how a specific loan calculation affects you.

Bottom line

The Rule of 78 front-loads interest to favor lenders and reduces the financial benefit of early repayment. Its practical impact is smaller for short loans but significant for longer ones (where it’s still permitted). Always confirm the interest calculation method and consider alternatives if you anticipate prepaying.