Rule of 78 for car loans: Everything you need to know

Whether you're looking to raise some spare cash to tide you over difficult times, or simply to replace your current ride with something different, you will need to refinance your car loan.

Since most car loans operate on the 'Rule of 78' when it comes to early repayment, we have drafted up an easy-to-understand guide explaining all that this rule entails, so you can know just what you're getting into with your next car loan, and hopefully walk away with a better idea of how much you need to pay when it comes to selling your car!


What is the rule of 78?

When it comes to early repayment of car loans, most banks here will utilise the rule of 78 as the method for calculating the total outstanding owed on an existing loan.

Applying the rule of 78 changes the distribution of your monthly payments so that as opposed to a flat rate loan, a greater portion of it goes towards paying off the interest charges rather than the principal in the first half of the loan tenure.

What this means is that a loan that utilises the rule of 78 will land you will with a larger outstanding principal and thus a larger amount still due, as opposed to a flat rate loan.

And why 78? That's because a 12-month loan starting from January would have the interest payments falling in the proportions:

12 + 11 + 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 78

So the amount of loan interest paid for November will be twice that paid in December, while that amount for October will be thrice that paid in December. If you were to add the proportions for a 12-month loan together, you would end up with a total of 78, thus the name.

Once you breakdown the rule of 78 into a simple formula, it becomes easier to understand.


Why the rule of 78?

So why do banks use this method? After all, isn't calculating using the flat rate method so much simpler?

Well, it would be yes. But to the banks, the old adage always rings true: Time is money.

When you sign up for a bank loan, you are basically giving the bank, in exchange for the cash to buy your car, an income stream. You agree to pay the bank more than the amount borrowed, in exchange for cash now. This is because in the world of finance, having money now is better than having money later, so compensation is due.

Arranging for early repayment cuts off the planned future income stream for the bank, so now it not only has to look for a new source of income, it also expects the compensation to be consummate with the length of the remaining loan term.

By calculating your loan settlement based on the rule of 78, the bank has a formula to ensure that those that repay on their loan early will be hit with a larger financing and loan repayment cost (as opposed to calculating on the flat rate method), representing a larger compensation to the bank for the longer income stream lost, while those that refinance their loan at the end of the loan term will not be hit as hard. Once again, this is because the effect to the bank’s income stream is not as severely affected if you choose to fully repay the loan later into the loan term.


And what does this mean to me, the borrower?

At this point I think it will be best to use an example to best illustrate just how your financing costs can change with a loan the adopts the rule of 78.

For simplicity's sake, let's assume you take a flat rate loan of $10,000, with an interest rate of 3% per annum and a loan term of just one year. Additionally, let us assume that this loan allows you to simply pay off the full oustanding balance on your loan without any additional or administrative charges.

The loan schedule would look like this:

Month	Principal payment	Interest payment	Outstanding loan balance
January	$833.33	$25	$9,166.67
February	$833.33	$25	$8,333.34
March	$833.33	$25	$7,500.01
April	$833.33	$25	$6,666.68
May	$833.33	$25	$5,833.35
June	$833.33	$25	$5,000.02
July	$833.33	$25	$4,166.69
August	$833.33	$25	$3,333.36
September	$833.33	$25	$2,500.03
October	$833.33	$25	$1,666.70
November	$833.33	$25	$833.37
December	$833.37	$25	$0.00

However, if you were to refinance the loan early, and the bank were to adopt the rule of 78 when calculating your outstanding loan balance, this is what your loan schedule would be adjusted into:

Month	Principal payment	Interest payment	Outstanding loan balance
January	$812.18	$46.15	$9,187.82
February	$816.03	$42.30	$8,371.79
March	$819.87	$38.46	$7,551.92
April	$823.72	$34.61	$6,728.20
May	$827.56	$30.77	$5,900.64
June	$831.41	$26.92	$5,069.23
July	$835.26	$23.07	$4,233.97
August	$839.10	$19.23	$3,394.87
September	$842.95	$15.38	$2,551.92
October	$846.79	$11.54	$1,705.13
November	$850.64	$7.69	$854.49
December	$854.49	$3.85	$0.00

We used a simple rule of 78 formula to calculate all the outstanding loan balances. You can try it too!

Note that in both schedules, your monthly payment remains the same - you are still financing a $10,000 loan at a 3% per annum rate, and paying $858.33 every month to amortise the loan to $0.00 at the end of the year - but the proportion of the monthly payment that goes into supporting the interest and principal has been altered.


What can I do to avoid paying a hefty refinancing sum?

The first and most important difference note between both financing schedules is the fact that, as described above, when comparing between the payment schedules within the same month, your outstanding loan balance is always more when utilising the rule of 78 as opposed to the flat rate method.

This means that no matter at which month you opt to repay a loan, your remaining amount still owed to the bank that is utilising the rule of 78 is always greater than the flat rate method.

Does this mean that as a borrower you're always disadvantaged? Well, not necessarily. If you were to compare difference between the outstanding loan balance of the two schedules across the months, you will find that it peaks exactly between June and July (halfway through the loan term), and drops back down at both the start and the end.

So clearly one simple solution to avoiding a hefty financing sum is to avoid being tempted by lower monthly repayments and instead take a loan that has a shorter term length whenever possible. If you are buying a car that you do not intend to keep for more than three years, for example, then clearly obtaining a five-year loan will land you within the worst periods to repay your bank loan when you eventually sell your car.

Of course, the more keenly-eyed among you would have spotted that you also have the option of repaying the loan very early in the loan term. If, for example, you were to pay the loan in February of our above example, you would only be paying an additional $38.45, as opposed to an additional $51.91 in March. This is because in the early stages of the loan the full difference between the scheduling has yet to fully materialise.

However, because the banks and car dealers are obviously already aware of this effect on the loan schedule, it is not uncommon to find additional early repayment penalties (on top of the regular penalties, that is) when opting to refinance a car loan in its earliest stages.

Since dealers also frequently charge an additional penalty for cash payments, another option that still remains viable for those that absolutely despise owing money to the bank is to repay the loan the moment these additional penalties no longer apply.

But here's the catch: If we use our example above again, even assuming there were no additional penalties for extra-early repayment, you will note that the borrower would have paid a total of $88.45 (interest charges for January and February, at $46.15 + $42.30) simply to borrow $10,000 for two months.

So while the difference in outstanding balance may still seem small at February, you have to bear in mind that the borrower has already paid a larger portion of the total $300 interest charge in the first two months alone. To many, this will look hardly worth it when the original bank loan rate was only 3% per annum.


 
Looking for a replacement to your current car? You might also find these articles handy!

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Calculate your car loan interest for early settlement using Rule of 78

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