The Rule of 78's and how it applies to most auto loans

Your automobile finance contract is very likely NOT a simple interest loan, but a precomputted loan.

Every finance contract that I've ever seen used by an auto dealer was a pre-computted finance contract.

You should understand that with pre-computted loans, the borrower not only owes the lender the principal amount borrowed, but the finance charge as well. If $10,000 is lent and the pre-computted finance charge is $3,000, the borrower owes the lender $13,000 at the time the loan is made, whereas a simple interest borrower owes the lender $10,000 principal & monthly interest on the unpaid balance.

The Rule of 78ths applies to loans where the full term finance charges are calculated before the loan is made.

You'll find the loan FINANCE CHARGE in the FEDERAL TRUTH-IN-LENDING DISCLOSURES (usually in an outlined box on your finance contract)

Also known as the Sum-of-The-Digits method, the Rule of 78s is a term used in lending and refers to a method of yearly interest calculation. The name comes from the total number of months' interest that is being calculated in a year.

A simple fraction (for this example we'll use 12/78ths) consists of a numerator (the top number, 12 (months) in the example) and a denominator (the bottom number, 78 in the example).

The denominator of a Rule of 78s loan is the "Sum-of-The-Digits"; in English that's the sum of the number of payments in the loan.

For a 12 month loan, the denominator is 78 (12/78ths as a fraction) (1+2+3+4+5+6+7+8+9+ 10+11+12=78).

For a 24 month loan the denominator is 300 (24/300 as a fraction) and so on. (78+13+14+15+16+17+18+19+20+21+22+23+24=300)

For a 12 month loan, 12/78ths of the finance charge is assessed as the first months' portion of the finance charge; 11/78ths of the finance charge is assessed as the second month's portion of the finance charge and so on.

This method allows the lender to earn the greatest amount of interest at the beginning of the loan. (He only earns 1/78th of the finance charge on the 12th and last payment)

For example:

Assume a 12 month loan term and $1,000 as the total finance charge.

A simple interest loan would divide the interest equally over the 12 month term and the portion of each monthly payment applied to finance charges would be $83. (Numbers are all rounded to the nearest dollar) If you pay the loan off after 6 months you will have paid $500 in finance charges.

In a pre-computted loan, the portion of your first monthly payment applied to the finance charge would be $154. (12/78ths) The second months finance charge would be $141. (11/78ths) The third month's portion would be $128. (10/78ths) and so on. The 12th and last payment would include a finance charge of only $13. (1/78ths). If you pay this loan off after 6 months, you will have paid $731. in finance charges.

That's a difference of over 23%; on loans with identical finance balances, interest rates, and terms. And this is only a 1 year loan with only $1000 in finance charges. You can imagine what the difference would be in a 5 year loan with 4 or 5 thousand dollars in finance charges.

It's for this reason that many loans are sold to other lenders well before term, once the interest earnings have been maximized.

This is an accurate interest model only based on the assumption that the borrower pays only the amount due each month. If the borrower pays off the loan early, this method maximizes the amount paid by applying funds to interest before principal.

Once the finance charge has been identified, the Rule of 78s is used to calculate the amount of the finance charge to be rebated (forgiven) in the event that the loan is repaid early, prior to the agreed upon number of payments. You can use this formula to calculate an accurate amortization schedule for your new loan.