The Rule of 78

When taking out a loan from a bank or other lender, the borrower usually arranges to repay the loan with a fixed interest rate by a specific date in a set number of equal installments. The rule of 78 is one way in which lenders calculate how much interest the borrower should have paid at any stage during the repayment period of a fixed rate installment loan.

The number 78 derives from the 12 monthly parts of a one-year period. The sum of those parts (12+11+10+9+8+7+6+5+4+3+2+1) is 78. Therefore, for a loan with a one-year duration, the borrower pays 12/78ths of the interest in month one, 11/78ths in month two, and so on down to 1/78th in month twelve.

The rule of 78 takes into consideration the fact that the borrower pays more interest in the beginning of a loan and less interest as the debt is reduced. Because each repayment installment is the same size, the proportion used to pay off the amount borrowed increases over time, whereas the proportion representing interest decreases.

Should the borrower wish to repay the loan early, the lending institution will use the rule of 78 to determine how much interest they have to pay. In this situation, the borrower may be unpleasantly surprised by how much of the capital sum of the loan remains outstanding.