BACK TO BASICS, Continued—Wouldn't you like to be one of the few people in the world who understands how the Rule of 78s works, and why?
OK then. Read on.
The Rule of 78s, also known as the sum-of-the-digits principle, is a methodology for determining the unearned finance charge on a precomputed or add-on interest contract. See my prior blog by clicking here for a discussion of what a precomputed interest contract means.
The reason for the reference to “78” is because that number—78—is the total of the numbers “1” through “12” added together. That is, 1+2+3+4+5…+12 = 78. Why 12? Because there are 12 months in a year. Everyone knows that, so what?
The what is that pursuant to this Rule of 78s, interest on a one year precomputed interest contract is deemed to be earned in the following manner:
- in month one, 12/78s of the precomputed interest is earned;
- in month two 12+11/78s, or 23/78s has been earned;
- in month three 12+11+10/78s, or 33/78s has been earned;
- in month four 12+11+10+9/78s, or 42/78s has been earned…and so forth.
This methodology means that after three months of a one year contract term (i.e., ¼ of the contract term), 42% of the finance charge has been earned. After four months (1/3 of the contract term), over one-half of the finance charge has been earned.
Let's take a look at the rationale behind the methodology of earning finance charge on this accelerated basis.
Finance charge is essentially the compensation to the lender for the extension of credit. And, the costs of extending credit are not spread evenly throughout the loan term. Rather, costs are for the most part “front loaded.” That is, the costs of taking and evaluating a credit application, obtaining a credit report and underwriting the borrower, documenting a loan, and setting up the loan account on the books of the lender, all occur at the outset of the lending relationship. Recovery of such costs early in the loan life-cycle is fair and appropriate.
Lending on a precomputed interest basis is unlike mortgage lending, where “prepaid points” can cover such costs. Further, in traditional installment lending, the creditor is generally not permitted to charge the borrower other fees that would compensate for preparing documents and examining credit.
And, unlike in a simple interest or interest-bearing loan, the borrower's cost of credit does not increase daily in the event of an untimely payment.
Practice Pointer: The next time you are challenged by a reader of The Pew Charitable Trusts October 2018 paper, State Laws Put Installment Loan Borrowers at Risk, you are now prepared to respond authoritatively on the issue of the Rule of 78s.
Please note: This is the thirty-third blog in a series of Back to Basics blogs, in which relevant and resourceful information can be easily accessed by clicking here.