"Rule of 78s"

[NNN0LHI]

http://www.bankrate.com/brm/news/auto/20010827a.asp

Steer clear of the perilous 'Rule of 78s'

By Lucy Lazarony • Bankrate.com

This is one rebate auto shoppers should avoid.

Some auto lenders still use the archaic and costly "Rule of 78s" formula to calculate a rebate of finance charges when a customer pays off a loan early. This rebate is actually a sneaky prepayment penalty.

"The Rule of 78s is a historical anachronism," says David Rubinstein, vice president of the Virginia Citizens Consumer Council. "It's simply another way of padding a loan."

The Rule of 78s is a mathematical formula that was devised in the days before modern calculators. The formula was a quick way for lenders in the 1920s and 1930s to estimate payoff amounts when a customer paid ahead on an installment loan. It's still around today. snip

Wrong way

For a borrower looking to end an auto loan early, there isn't a worse way a lender could calculate your payoff amount. The Rule of 78s formula packs extra interest charges into the early months of a loan. Using Rule of 78s, a lender typically collects three-quarters of a loan's interest in the first half of a loan term.

There are two basic types of auto loans: simple interest loans and pre-computed loans. The Rule of 78s can only be applied to pre-computed loans that are paid ahead of schedule. To understand why this is such a lousy deal for consumers, you have to understand how a pre-computed loan works.

[SheilaT]

1. Penalties for paying off a loan, any loan, early

should be against federal law.

I recently bought a house, and it was important to me that there be no prepayment penalties. If I pay it off tomorrow or two months before the final payment is due, no penalty.

[NNN0LHI]

2. I think the penalty is already built into most home mortgages

They frontload the interest on those loans too. On a 30 year loan for the first decade or so most of what we pay every month is interest. That way if the person refinances for a better interest rate down the road the bank who gave the original loan already has made most of its profit. And then the second loan is written the same way so the process of paying mostly interest every month for a decade begins all over again. Can't get ahead like that.

Don

[SheilaT]

3. I'm not sure it's strictly true

to say that the interest in front loaded. It's just that you pay the interest on whatever is actually owed each year.

For example, say you borrow $100,000 for 30 years. The first year you're paying 6 percent (or whatever percent) on the full $100,000. But you also pay some of the principal (assuming you didn't go for a negative amortization loan, where you pay less than the full interest owed, meaning the principal owed gets larger). So the second year you pay 6% on maybe $98,000. And so on.

I got a 4.7% interest rate. Which means that over thirty years my total interest paid will be less than the loan amount. Somewhere above 5% the total interest becomes as much as the total loan. And of course, the higher the interest rate, the higher the total interest payments.

I feel very happy to have such a low interest rate, and I do hope to pay off early.