WHAT'S IT ALL ABOUT?

The Rule of 78 is used for car and other installment loans.  It is a method of allocating a loan's interest and principal.

The Hire Purchase Act requires use of the rule of 78 for car loans where the car is valued at less than $55,000 without COE.  (This is about $83,000 with COE.)

The rule applies most of the installment payments in the early years of a loan to payment of interest rather than principal. 

Therefore, if you repay a 10 year loan in just 4 years, you will have more than 6 years of principal to repay.

An alternative to the rule of 78 is known as “monthly rest”.  It is a variable rate which calculates interest charges using the effective interest rate (EIR).  With this method, you pay interest charges only during the period that you borrow the money.  

For this reason, “EIR with monthly rest” is considered a fairer method of calculating interest rates, especially when the loan is repaid before the due date.

HISTORY

Rule of 78 was popular as a short-hand method for calculating the remaining interest on a loan in the days before financial calculators. 

In those early days, the rule of 78 was applied to all loans.  Today it remains only for car loans.

In other countries, like the US, the rule of 78 has been dropped. It is not permitted for car loans of more than 5 years and it is rarely used for loans less than 5 years.  

BANKS: THE RULE OF 78 IS OK!

Singapore banks take the position that the rule of 78 results in a fixed-rate loan which car-buyers prefer. 

Banks also point out that the rule of 78 makes it only slightly more expensive to repay a car loan early.  As an example, take a $90,000 7-year car loan charging 2.5 per cent flat rate interest. 

If redeemed at the end of year 3, it will cost $240 more under the rule of 78 than it would if interest payments were calculated using the effective interest rate (EIR) with monthly rest.  (This is a variable rate where interest rates are recalculated monthly).

While $240 on a $90,000 loan is not much, it is a substantial amount when aggregated over many car loans. 

If banks switched from the rule of 78 to EIR, the total foregone interest would likely amount to tens of millions of dollars, which may explain the preference of banks for using "the rule of 78 + flat rates" for car loans.

HOW ABOUT "FIXED RATES WITH NO RULE OF 78"?

Banks state the problem as a choice between two alternatives: (i) fixed rates -- (which use "the rule of 78 + flat rates") OR (ii) variable rates -- (using EIR with monthly rest). 

Banks overlook a third possibility: fixed rate loans using EIR without the rule of 78. 

Other familiar loans use EIR without the rule of 78, including home loans, personal loans and credit card loans. 

Take home loans. They offer two choices: variable and fixed rates -- with fixed rate loans costing more. 

Home loans also quote only the effective interest rate.  They do not quote a flat rate and do not use the rule of 78.

If applied to car loans, a buyer could choose between a 10-year fixed rate loan costing, say, 5 per cent vs. a 10-year variable rate loan costing 3 per cent.  Both 5 and 3 per cent are effective rates. Since these are the interest rates you are really paying, there is no need to mention a flat rate.

The Hire-Purchase Act was amended as of October 1, 2004 and gave banks more leeway to set terms and conditions as they see fit.  The principal of "buyer beware" has become more important for car loans and other installment loans.

But things haven't changed very much.  Banks still follow the antiquated "rule of 78 + flat interest rates".   No Singapore bank has switched to a "fixed effective interest rate" model such as the one suggested above.

FORMULA

Assume a loan is repaid early. Here is the formula for calculating the remaining interest to be returned to the borrower on a loan using the rule of 78:

Rebate of interest  =   [(n (n+1)) / (N (N + 1))] x TI

n = the number of months remaining on the loan

N = the total loan period

TI = the total interest charged over the period of the loan

You may recognize this as the sum of the year’s digits formula used in accounting to determine the rate of depreciation of assets. 

This depreciation method is not permitted under Singapore or US GAAP (Generally Accepted Accounting Principles) because of the same problem that arises in its use under the rule of 78: it charges most depreciation in the early years which results in overly aggressive depreciation of assets.