Rule of 78
Categories: Metrics
The “Rule of 78” is kind of like numerology for loan payments. It’s a way for lenders to front-load interest on a loan so they’ll still make a buck, even if the borrower pays off the loan early.
But before we get into the nitty-gritty details here, let’s just go ahead answer the question on everyone’s mind: why is it called the “Rule of 78?” Well, let’s start with the fact that there are 12 months in a calendar year. Throw some simple arithmetic into the mix, and…
1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78
Okay, now let’s say Beatrice just took out a 12-month loan for $10,000 with a 15% fixed interest rate. Her lender calculates the total interest charge for the loan: $1,500. Then he divides that amount by twelve ($125) and adds that to Beatrice’s monthly payment. This means she’s got twelve equal payments of $958.33 ($833.33 for the loan amount plus $125 for the interest).
Now here’s where stuff gets fun…and a little more complicated. Let’s divide the total interest for the loan by 78, which gives us $19.23. During the first month, when Beatrice has twelve months left on the loan, the payment amount will be divvied up so that 12/78 of the total interest amount will go to the lender, while the rest will go toward the principal. That’s $230.76 in interest and $727.57 toward the principal, for those keeping track. During the second month, when she’s got eleven months left on the loan, 11/78 of the total interest amount will go toward paying off the loan’s interest, which means $211.53 in interest and $746.80 toward the principal. Every month, more of Beatrice’s payment goes toward the loan principal, and less goes to interest.
If she takes the full twelve months to pay back the loan, this really doesn’t matter. But if she decides to pay off the loan early, like in six months, the lender still benefits, because those first few payments are so interest-heavy. Think of it this way: if she paid $125 in interest every month for six months before paying the loan off in full, she’d end up paying a total of $750 in interest. Under the front-loaded Rule of 78, she’d end up paying $1,096.11 in interest.
If this sounds a little unfair, federal legislators tend to agree, which is why the Rule of 78 is illegal on loans that are for longer than 61 months.
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Finance: What is call protection, and ho...2 Views
And finance Allah shmoop what is called protection and how
does it work So you wish this term was about
preventing those annoying telemarketers who call you right in the
middle of dinner hoping to sell you X and satellite
subscriptions But it's not Call protection has to do with
a bond being called early meaning that the company that
issued the bond I either company that borrowed the money
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a percent or two premium above that figure when they
call the bond So why would you want protection against
this happening Like isn't it a good thing that bonds
get called back by the people who borrow the money
and then get fully paid off Well the answer No
not always Let's say a bond is issued in a
high interest rate environment like the Fed is trying to
cool inflation so they have short term high interest rates
or high short term borrowing costs That calm six percent
for one year paper eight percent for five year paper
for the best borrowers and a bond you invested in
was yielding two hundred basis points above those U S
government bonds or in this case and say it's five
year paper That's a yielding ten percent But then inflation
cooled and the Fed suddenly lowered rates a lot and
that six percent paper a few years later pays only
four percent and that five year eight percent paper is
now down Teo five percent Well the company that issued
its bond paying ten percent interest could refinance that bond
today at only seven percent interest And they do Right
so they're saving three points of interest Unusually you know
like a billion dollars of Borrow They call the bonds
back home to the mother ship Yep they paid them
all off Maybe with say a two percent premium Big
Woop so that a thousand dollars par unit of the
bond gets one o two or a thousand twenty to
pay it off and retire it well thank you The
investor in that bond who thought you were getting ten
percent a year in interest for a while You can't
even find paper like that in the market The best
you can do of similar risk in duration is only
seven percent so you've lost three percent per year compounded
interest by having those lovely ten percent yielding Bonds called
its protection against this lost yield that bond holders want
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that were uncool a ble or call pretty detected the
company couldn't just buy them back and refinance with cheaper
paper So yeah that's why it's always nice to have
your bonds protected and for even greater security we recommend 00:02:25.28 --> [endTime] investing in a Rottweiler