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In 1992, the U.S. Congress outlawed the use of the "Rule of 78s" formula in closed-end loans that are longer than 61 months.
U.S. Rep. John LaFalce, D-N.Y., had introduced a bill (H.R. 1054) that would eliminate the use of the Rule of 78s formula in credit transactions.
Whether a Car Loan lender can apply the "Rule of 78s" method to installment loans of five years or less is a matter of state law. Currently, 17 states (Listed at the Bottom) prohibit the practice.
Some Car Loan auto lenders still use the very old 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 way of padding a Car Loan.
The Rule of 78s is a mathematical formula that was devised in the days before modern calculators. The Car Loan 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.
Also known as the sum-of-the-digits method, the Rule of 78s gets its name from the sum of the digits one through 12 the number of months in a year.
Paying Off A Car Loan Early
For a borrower to pay off a Car 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 Car Loan: simple interest loans and calculated car loan. The Rule of 78s can only be applied to calculated car 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-calculated loan works.
With a pre-calculated car loan, the interest owed over the life of the car loan is calculated using a standard amortization table. If you (agree) and sign for this type of loan, you're obligated to pay back principal plus the full amount of interest that will accrue over the entire term of the loan.
To sum up, interest on a Car Loan is calculated in advance and you are responsable for every cent of it if you agree and sign.
In contrast, with a simple-interest Car Loan you're charged interest each day based on the balance you owe. So the quicker you pay down your balance the less interest you pay. A simple interest car loan with no prepayment penalties rewards customers who pay ahead.
Pre-Pay a Car Loans with a pre-calculated loan that applies the "Rule of 78s" method to prepayments and you'll be slammed with a penalty, disguised as a rebate.
Interest padding in Car Loans (Can be Likely)
Let's say you're ready to pay off your 48-month car auto loan a year early. Because you signed on for a pre-calculated loan, you're on the hook for 48 months worth of interest even though you're paying off the loan in 36 months.
But your lender is going to do you a "favor." You don't have to pay 48 months worth of interest. Instead, he's going to determine your payout amount including a "rebate" for those 12 months worth of finance charges you won't have to pay.
But your payout amount won't be what you deserve. The reason? Using the "Rule of 78s" method, your Car Loan lender applies more of your previous payments toward interest and less of your previous payments toward principal.
Since less money is applied toward principal Car Loans, the amount you owe will be higher than expected. The earlier you try to pay off one of these car loans the more you'll have to pay. The higher the interest rate, the more that payoff amount is going to hurt.
Simple interest Car Loans are now the norm in the auto financing business. The vast majority of car auto loan lenders do not use calculated car auto loans and they do not use the Rule of 78s method to calculate prepayments.
The calculated Rule of 78s car auto loans that do exist today tend to be found in the (Bad Credit) subprime market. Consumers with just ok credit should be aware.
Interest Car Loans Rebates Can Be BAD
Don't let this happen to you. Be leery of signing any financing contract that mentions a refund or rebate of interest. That's a sure sign you're about to sign on for a pre-calculated car loan and not a simple interest loan. Don't ask You Can Read.
And because it puts the most money in his pocket, there's a good chance that a lender offering a pre-calculated car loan will apply the Rule of 78s formula to all prepayments.
Check the front of a car loan contract to see whether it allows a refund or rebate of interest. Flip over to the back of the contract and look under the section on prepayments for further details. Some contracts even mention Rule of 78s.
Try to Avoid getting a Car Loan that apply the Rule of 78s formula to prepayments. If you've already signed on the dotted line, you're best bet is to make your payments as scheduled. Because of the penalties, there's really no point in paying ahead.
"Buy here, pay here" auto Car Loan lots and lenders that specialize in offering loans to borrowers with badly damaged credit may offer these consumer-unfriendly loans.
(States As Mentioned Above)
States outlawing use of the Rule of 78s formula in installment loans of five years and less:
Arizona
Delaware
Idaho
Iowa
Kansas
Maine
Maryland
Massachusetts
Michigan
Minnesota
Nebraska
Nevada
New Hampshire
New York
Oregon
South Dakota
Vermont
