Loan Information: What is the Rule of 78s?

Knowing when the rule of 78 is applied is essential to understanding your loan information. This rule is more commonly applied to auto loans than to home loans, but it can be used against a mortgage borrower. In simple terms, the rule of 78 applies extra charges to pay off a loan early. Here is why:

Simple Interest Loan

On a simple interest loan, the largest interest payments will be assessed when the principal is greatest, usually the beginning of a loan. When you make a monthly payment, interest is paid first, and the remainder goes toward principal. Each month, your principal is slightly reduced, and your interest charges on that principal should get lower. When you go to pay off the loan, there will not be a high penalty.

Rule of 78 Loan

With a rule of 78 loan, you are charged a disproportionate amount of interest in the first part of the loan. Your principal is not actually reduced very much in the beginning, and you are essentially only making interest payments for some time. As a result, when it is time to pay off the loan early, you will have the entire principal or majority of the principal left to repay. This is disguised as a type of rebate, but it is actually a fee assessed by the lender for repayment.