Early loan payoffs can dramatically impact lender profitability, especially when borrowers escape paying their fair share of interest costs. A specific precomputed interest method offers lenders a way to protect their returns through front-loaded interest payments. Because more interest is collected earlier in the loan term, the total payoff amount is slightly higher if the borrower repays the loan early, helping offset lost future interest. 

This guide covers the calculation formula, provides examples, explains legal considerations, and shows how this method compares to simple interest for strategic lending decisions.

What Is the Rule of 78 in Lending?

The Rule of 78, also known as the interest rule of 78, is a precomputed interest calculation that assigns a greater portion of total interest to the early months of a loan term. This method gets its name from the sum of digits 1 through 12, which equals 78.

Lenders typically use the rule of 78 method for short-term installment loans, particularly auto loans and personal loans with terms of 12 months or less. 

Knowledge of what the rule of 78 is helps lenders evaluate whether this precomputed approach fits their portfolio strategy versus simple interest calculations.

How Does the Rule of 78 Work?

The Rule of 78 works by assigning weighted portions of total interest to each payment period, with higher weights given to earlier months. This front-loaded approach means borrowers pay significantly more interest in the first half of their loan term.

The basic concept uses a fraction where the numerator represents remaining months and the denominator is the sum of all months (78 for a 12-month loan). For each payment, lenders calculate:

Interest = (Number of remaining months ÷ 78) × total interest

Here’s how the rule of 78 works for the first two months of a 12-month loan with $54.98 total interest:

• Month 1: (12/78) × $54.98 = $8.46 interest. (That is 13 cents that did NOT go to pay down principal and is the source of the fact that the payoffs are higher.)
• Month 2: (11/78) × $54.98 = $7.75 interest

This demonstrates the declining interest pattern, where each month’s interest portion decreases as the loan progresses. 

So, how does the rule of 78 work compared to simple interest? Well, the answer lies in this predetermined allocation structure. The remaining payment amount after interest goes toward principal reduction.

Rule of 78 Formula and Calculation

The rule of 78 formula requires calculating the sum of digits for your loan term, then applying weighted fractions to determine each month’s interest allocation. Let’s walk through a complete example using a $1,000 loan with $54.98 total interest over 12 months.

• Step 1: Calculate the sum of digits: 1+2+3+4+5+6+7+8+9+10+11+12 = 78
• Step 2: Apply the rule of 78 formula for each month: Interest = (Remaining months ÷ 78) × $54.98
• Step 3: Create the complete amortization schedule:

This example of how to calculate the rule of 78 shows the front-loaded nature of interest payments, with $8.46 in the first month compared to only $0.70 in the final month. 

Rule of 78 vs. Simple Interest: What’s the Difference?

The rule of 78 vs simple interest comparison reveals significant differences in how lenders calculate and allocate interest throughout a loan term.

With simple interest, borrowers benefit from early payoffs because they only pay interest on the outstanding principal. The rule of 78 vs simple interest debate often centers on fairness to borrowers versus predictability for lenders. 

It shows why lenders might choose one method over another based on their risk tolerance and borrower demographics.

Thinking about offering variable-rate loans? Read our article titled, Should You Offer Variable Rate Loans?

Is the Rule of 78 Legal?

The interest rule of 78 remains legal in most U.S. states, though many have imposed restrictions on its use. Federal regulations prohibit using this method for mortgages and loans with terms longer than 61 months under the Truth in Lending Act.

Several states have banned or limited the interest rule of 78 for consumer loans:

• California prohibits the method for most consumer loans
• Many states require clear disclosure when lenders use this calculation method
• Some jurisdictions limit its use to specific loan types or amounts

Lenders must check state-specific regulations before implementing these loan structures. The method has become less common as borrowers have become more aware of its cost implications and simple interest calculations have become the industry standard.

Pros and Cons of Using the Rule of 78 Method

The rule of 78 method offers distinct benefits and drawbacks depending on your perspective as either a lender or borrower.

Pros for Lenders

• Predictable interest revenue: This approach provides guaranteed interest income regardless of payment timing or early payoffs. Lenders can accurately forecast returns at loan origination without worrying about borrowers reducing total interest through early payments.
• Simpler payment allocation: Once calculated, the interest allocation remains fixed throughout the loan term. This simplifies accounting and reduces the need for complex recalculations based on payment timing or principal balance changes.

Cons for Borrowers

• Higher early payoff cost: Borrowers who pay off loans early still owe a significant portion of total interest, unlike simple interest loans where early payoff reduces total interest costs. This can make refinancing or early payoff financially disadvantageous.
• Can be confusing or seem unfair: The front-loaded interest structure isn’t immediately obvious to borrowers, who may not realize they’re paying more interest early in the loan term. This can lead to customer dissatisfaction and complaints about loan terms.

How Nortridge Supports Rule of 78 Loan Structures

At Nortridge, we support multiple interest calculation approaches within our loan management platform to help lenders optimize their loan structures.

Our software provides built-in Rule of 78 functionality for lenders who want to implement precomputed interest structures. It handles complex mathematical operations automatically while maintaining accurate records for compliance tracking.

Automated Calculations

• Configure precomputed interest loans with accurate amortization schedules
• Handle complex mathematical operations automatically
• Maintain detailed audit trails for compliance tracking

Flexible Configuration Options

• Support both this method and simple interest calculations
• Set up loan products with preferred interest calculation methods
• Track early payoff scenarios with precision

Comprehensive Reporting

• Generate accurate borrower statements showing interest allocation
• Analyze the performance of different interest calculation methods
• Make data-driven decisions about appropriate loan structures

Our Rule of 78 support integrates seamlessly with other Nortridge features, allowing lenders to manage diverse loan portfolios efficiently while maintaining regulatory compliance.

Schedule a demo to explore our configurable loan management platform and discover how we streamline operations for lenders across the nation.

For more information on calculating interest, read our article: How to Calculate Interest on a Loan

Frequently Asked Questions

Get quick answers to common questions about this precomputed interest calculation method and how it impacts lending decisions.

1. What is the Rule of 78 formula? 

Interest equals remaining months divided by the sum of digits, multiplied by the total loan interest amount.

2. Is the Rule of 78 still legal? 

Yes, in most states, for short-term loans. However, federal law prohibits it for long-term mortgages.

3. Why is it called the Rule of 78? 

The name comes from the sum of digits 1 through 12, which equals 78 for annual loans.

4. How is interest calculated using Rule of 78? 

Interest is precomputed and allocated to early months using weighted fractions of total loan interest.

5. What happens if I pay off a Rule of 78 loan early? 

Borrowers still owe most of the predetermined interest, unlike simple interest loans, where early payoff saves money.