An old mathematical formula who’s first recorded use was in 1935 in the state of Indiana in the pre-computer era. Its purpose was to easily allow lenders to estimate what the payoff would be if a client decided to fully pay an installment loan ahead of time. Although not widely used today it is still around especially when is comes to costumers with bad credit and in the subprime markets.

Rule of 78s, also know as the sum-of-the-digits method, can only be used with one type of loan; pre-computed loans, the other being simple interest loans which are more common.

With a simple interest loan you are charged interest on a day to day base according to what the balance is. It is most advantageous to payoff your loan as fast as possible to avoid paying interest on your loan amount. You’ll be saving a lot of money this way.

On the other hand a pre-computed loan has prepayment penalties often referred to as a rebate. Here’s how it works; the lender calculates in advance the amount of the initial loan know as the principle, and the interest that will be accrued during the full term of the loan. You are responsible for paying the combined cost of these two amounts regardless of when you decide to payoff your auto loan.

Rule of 78s comes into play if you approach the lender before the end of the loan term is due and request to payoff the balance of the loan. The lender in turn applies Rule of 78s by attributing more of your previous payments as interest, rather than principle. This leaves you with a larger balance to pay off and therefore more interest to payoff as a consequence. The sooner you try to pay it off, the more you’ll have to payoff.

Rule of 78 has been prohibited in 17 states for pre-computed loans of 5yrs or less due to a U.S. Congress ruling in 1992 that outlawed it for 61 months or more close-ended loans. Bill H.R. 1054 was introduced March 15, 2001, by U.S. Representative John LaFalce to eliminate to the use of Rule of 78s in credit transactions. After being referred on April 10, 2001 it died. No further action has been taken.

One sign to look for before signing a contract for an auto loan are the words “refund or rebate of interest” and of course “Rule of 78s”. This means you’re about to commit to a pre-computed loan. Sometimes it can appear on the front of a contract or on the back in the prepayment section. If you’re already bound by such a contract the best thing for you to do is respect the payment schedule and its terms.