Friday, June 19, 2009

The Perils of Rule 78

Investopedia explains Rule Of 78 as below:
* When paying off a loan, the repayments consist of two parts: the principal and the interest charge.
* The Rule of 78 weights earlier payments with more interest than later ones. If the loan is not terminated or prepaid early, the total interest paid between simple interest and the Rule of 78 will be equal.
* However, because the Rule of 78 weights the earlier payments with more interest than a simple interest method, paying off a loan early will result in the borrower paying more interest overall.

History of Rule 78
* The earliest official use of the Rule of 78s to calculate the unearned portion of a loan’s finance charge was in Indiana in 1935. Most loans then were for small amounts at low interest rates for short period like 12 months during the pre-computer era.
* The number 78 is actually the sum of 1 to 12 (1+2+3.....+11+12 = 78).
* Assuming a 12 month loan with interest of $1,000,
1st month - 12/78 x $1,000 = $153.85 will be your payment on this interest,
2nd month - 11/78 x $1,000 = $141.02 will be your 2nd month payment on this interest
12th month - 1/78 x $1,000 = $12.82 to be your 12 months payment on this interest.

This Singapore Case
* This rule 78 normally applies to Car loans where early settlement of the loan will entitle you to a rebate on the interest, calculated using this “Rule of 78” formula.
* If your loan amount is less than or equal to $55,000, your loan is bounded by the Hire Purchase Act. This requires you to pay the principal and interest that would have accrued over the entire period of financing.
* If the loan amount is more than $55,000, the loan is governed by the Common Law. If the interest is on a flat rate basis, the “Rule of 78” will also apply.

The Formula
R = [n(n+1)]/[N(N+1)] x TC
R represents the interest charges rebate;
n represents the unexpired loan period expressed in months;
N represents the original loan period expressed in months;
TC represents the total amount of interest over the loan period.

An Example
Car loan taken ==> $50,000
Interest Quoted ==> 3% flat rate x 7 years (84 months)
Total Interest ==> $50,000 x 3% x 7 = $10,500
Loan + Interest ==> $60,500
Monthly Instalment ==> $60,500 / 12 / 7 = $720 per month

Decided to redeem the loan after 3 years
Total Instalment paid ==> $720 x 12 x 3 = $25,920
Number of months remaining ==> 48
Rule of 78 rebate ==> [n(n+1)]/[N(N+1)] x TC
==> [48(48+1)]/[84(84+1)] x $10,500
==> 0.329 x $10,500 = $3,459

Amount to repay after rebate
$60,500 - $25,920 - $3,459 = $31,121

You are actually penalised with this formula
* You had paid 36/84 = 42.8% of your tenor but the rebate is only $3,459/$10,500 = 32.9%. This differential will be greater if you choose to repay your loan much earlier.

Lock-in Period and Penalties
Be careful when your dealer or distributor is giving your cash rebate. There might be a catch.
a) Lock in period is the time frame where the bank applies a lock in period as long as 5 years to discourage you to go to another lender.
b) A Penalty charge will be applied if the loan is redeemed within the lock in period. The penalty rate differs from bank to bank, and it can even be a hefty 20% of the unearned interest.

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