Rule of 78 is a method used to apportion interest (charged on a flat rate basis) throughout the life of the loan.. This rule is also known as “sum of digits” method. In fact, 78 is the sum of the digits of the months in a year ie, sum of 1 to 12. In using this rule, the sum of digits of the loan period (in months) is always used as the base. Hence, for a 2-year loan, the sum of digits is 300, for a 3-year loan, sum of digits is 666, and so on. The formula for computing the sum of digits for any loan is:
Sum of digits = N (N+1)/2………where N is the loan period in months
In the flat rate basis of interest computation, the interest amount is computed as a lump sum upfront and added on to the loan amount to derive the monthly instalment repayment.
This method of interest computation is commonly used in hire-purchase transactions. Take for example, a two-year (24 months) loan of $10,000 at 4% flat interest, the interest amount of $800 (4% x $10,000 x 2) is added to the loan amount, making a total of $10,800. This amount is then divided by 24 months to arrive at the monthly repayment of $450. Of the monthly instalment of $450, a part of it goes to pay for interest, and the balance to repay the loan. How the interest of $800 is apportioned throughout the 24-month loan period is computed by using the Rule.
Each month, a fraction of the $800 is apportioned as interest charged for the month. For a two-year loan, denominator of the fraction is fixed at 300 (ie sum of digits of 1 to 24), and the numerator (for the first month) is the number of months in the loan ie, 24. Hence, in the first month, 24/300 of $800 is earned by the bank. In the following months, the numerator is reduced by one, every month, so that by the 24th month, the amount of interest earned is 1/300 of $800. The same methodology is used for longer loan tenors, eg in a 3-year loan, sum of digits from 1 to 36 is 666. The fractions for monthly interest apportionment will be 36/666, 35/666, 34/666, and so on until it reduces to 1/666 in the 36th month.
For a numerical illustration of how Rule of 78 works, please click here.