When you take out a loan, you pay back the money you borrowed plus interest. There are different ways lenders can calculate and allocate that interest. One method is called the Rule of 78. Commercial loan interest explained simply will help you make an informed decision when purchasing your next car, caravan, boat, motorcycle, truck, excavator or other asset.
What Is the Rule of 78?
The Rule of 78 is a way of dividing the total interest on a loan between your payments.
It gives more of the interest to the earlier payments and less to the later payments.
The name comes from adding the numbers 1 to 12:
1 + 2 + 3 + … + 12 = 78
For a 12-month loan, the interest is divided using these numbers:
12, 11, 10, 9, 8, 7, 6, 5, 4, 3, 2, 1
The first payment gets the largest share of the interest, while the last payment gets the smallest share.
Commercial Loan Interest Simple Example
Let’s say your loan has $1,200 in total interest over 12 months.
The first month’s interest allocation would be:
$1,200 × 12 ÷ 78 = $184.62
The second month’s allocation would be:
$1,200 × 11 ÷ 78 = $169.23
The amount continues to decrease with each payment.
Why Does the Rule of 78 Matter For Commercial Loans?
The Rule of 78 is especially important if you want to pay your loan off early.
Because more interest is allocated to the earlier payments, you may have already paid a larger portion of the scheduled interest by the time you decide to settle the loan.
This means you may save less interest than you expect by paying the loan off early.
It’s important to note that most lenders will have an early termination rebate of a portion of the interest if you cancel the loan early.
Rule of 78 vs. Simple Interest
With many simple-interest loans, interest is based on the amount of money you still owe.
As you pay down the loan balance, the interest charged can decrease as the interest is often calculated on the reducing balance.
The Rule of 78 works differently because it uses a set formula to allocate the total interest across your scheduled payments.
Is the Rule of 78 an Interest Rate?
No.
An interest rate tells you how much interest is charged on a loan.
The Rule of 78 is a method for allocating that interest between payments.
What Should You Check Before Taking a Loan?
CHECK THESE IMPORTANT COMPONENTS OF YOUR LOAN:
- The total interest you’ll pay.
- Your payment schedule.
- How interest is allocated.
- What happens if you pay the loan early.
- Whether there are early repayment fees.
- Whether you receive an interest refund when settling early.
Rules can vary depending on the type of loan and which Australian State or Territory you live, so always talk to AAA Finance to discuss further.
In Simple Terms
The Rule of 78 gives more weight to the earlier payments when dividing loan interest.
This can be important if you plan to pay your loan off early because you may not save as much interest as you would with some other interest-calculation methods.
Understanding the Rule of 78 can help you compare loans and understand the true cost of borrowing.
AAA Finance has assembled an expert team of brokers that considers your needs and compares them to over 40 lenders to work out which lender aligns with your future plans. Interest rebates on offer are different from lender to lender, so it’s important for us to consider all loans on offer.
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Finance is subject to lender approval, terms and conditions, fees and lending criteria. Not all applicants will qualify for all products or rates. Information provided is general in nature and does not take into account your individual or business circumstances. Please talk to your financial advisor before making any financial decisions.
