Sara Routhier, Managing Editor and Outreach Director, has professional experience as an educator, SEO specialist, and content marketer. She has over five years of experience in the insurance industry. As a researcher, data nerd, writer, and editor she strives to curate educational, enlightening articles that provide you with the must-know facts and best-kept secrets within the overwhelming world o...

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Joel Ohman is the CEO of a private equity-backed digital media company. He is a CERTIFIED FINANCIAL PLANNER™, author, angel investor, and serial entrepreneur who loves creating new things, whether books or businesses. He has also previously served as the founder and resident CFP® of a national insurance agency, Real Time Health Quotes. He also has an MBA from the University of South Florida. ...

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Reviewed by Joel Ohman
Founder, CFP®

UPDATED: Dec 7, 2012

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Are you ready to become rich? I know I am. Are you prepared to give people auto loans and then charge them for interest that never existed? I’m not, and hopefully you aren’t either.

There are some lenders out there who give people financing using an interest-calculating system called the rule of 78s to charge them for future interest.

Anyone with a moral vacuum in their heart can enjoy using the rule of 78 to make money from uninformed borrowers. Many borrowers don’t expect to be charged for interest that never accrued. Fortunately for unethical lenders, not all borrowers read the fine print on contracts or agreements they sign, let alone understand complex financing.

To be clear, the purpose of this article isn’t meant to teach unethical lending behavior, but instead it’s to teach current and future auto loan borrowers about the insidious rule of 78s. That said, let’s imagine you are an unscrupulous lender with more greed than King Midas.

Pay for the Future

As an unscrupulous auto loan lender, you want to do anything and everything you can in order to make money. Using the rule of 78s is a great way to get rich off of unsuspecting auto loan borrowers.

The rule of 78s is essentially a prepayment penalty. This insidious rule isn’t anything new. In fact it was created back in the early 20th century before calculators and computers existed (at least as we know them today). The number 78 in the rule of 78s doesn’t refer to any law code or number of guidelines, it’s just the total sum of the numbers 1 through 12 since there are 12 months in a year.

Auto loans with interest calculated through the rule of 78s work by obligating borrowers to pay back the principal plus the full amount of interest that will accrue over the entire term of the financing, even if it is repaid early. In effect, borrowers agree in advance to pay for most of the interest on a pre-computed auto loan the moment they sign the agreement.

So many borrowers have been hurt by the rule of 78s that it is illegal (at the federal level) for financing in excess of 61 months to be given. As a result, most car loans have terms of 36, 42, 48, or 60 months.

Contrasted with simple-interest auto loans, where borrowers are charged interest each day based on the balance they owe, it is easy to see how broken the rule of 78s is. Simple-interest car loans allow borrowers to save money the quicker they pay down their balance since they will owe less interest on that balance. Assuming a simple-interest vehicle loan doesn’t have any prepayment penalties, then customers get rewarded and save money by paying off their debt early.

So what happens when a borrower who got an auto loan featuring the rule of 78s decides to pay off his or her car debt early? Well, they face interest padding.

Painful Padding

Lenders try to coax borrowers into prepaying their debt by offering them a “rebate.” This rebate isn’t a rebate at all. Instead, it’s incentive for borrowers to pay their debt off early, fork over “prepayment penalty” cash to their lender, and allow that lender to have capital to relend to others.

Imagine a woman is going to pay off her 48-month auto loan in 36 months. Because her financing agreement features the rule of 78s, she is responsible for additional interest upon repaying her debt.

The rule of 78s allows her lender to apply more of her previous payments towards interest before it pays down principal. Since her previous payments aren’t applied toward the principal, the amount she owes will be much more than she expects. Any “rebate” her lender offers her for the 12 months of finance charges she didn’t accrue will be less than she deserves, and in fact only serves to calm consumers and make them feel like they’re getting a deal. Ironically, the earlier she pays off her debt and the higher her remaining interest will be, which directly translated to a more costly prepayment penalty. Needless to say, this is a profitable prospect for a greedy and unethical lender.

Obviously, unscrupulous lenders can make a killing by combining a high interest rate with a rule of 78s auto loan that will charge borrowers for interest that should never have accrued. Combined with the inexperience most borrowers have in understanding financial agreements (and the desperation of sub-prime borrowers), it is easy to see how some lenders line their pockets through the mistreatment of borrowers.

So if you have delusions of unethically accumulating wealth, the rule of 78s should be added to your arsenal. If you are a borrower looking for financing, you know what to look out for.