Early repayment of an instalment loan and the Rule of 78
If you intend to settle your instalment loan before it matures, you should check if there is an early repayment penalty and compare the fee against the interest expenses that you could save.
While the monthly repayment amount stays the same for an instalment loan, the apportionment of the principal and the interest differs for each instalment. The Rule of 78 is the method that most banks and financial institutions apply when apportioning the principal and interest for each instalment.
Under the Rule of 78, the sum of the number of monthly instalments in the loan is used to apportion the principal and the interest for each instalment. Using a 12-month tenor as an example, the sum of the number of monthly instalments is 12 + 11 + 10 +…3 + 2 + 1 = 78. From this, 12/78ths of the total interest is apportioned as the first month’s interest portion, 11/78ths of the total interest is apportioned as the second month’s interest and so on until the 12th month, at which time 1/78th of the total interest is apportioned as the last month’s interest. Under this rule, the apportionment of interest in the monthly payments decreases over the course of the loan period. Simply put, the borrower pays more interest and less principal in initial repayments; towards the end of the repayment term, more principal and less interest are paid.
Therefore, the later you pay off the outstanding balance of an instalment loan, the less you can save on interest. In some cases, early repayment fee could even be higher than the interest you could save. Consumers who intend to pay off an instalment loan before maturity should first approach the lending institution to check the unpaid principal amount, the early repayment fee and the amount of interest that could be saved. They should consider if the cost will outweigh the benefit.
Lending institutions may calculate the early repayment fee in different ways. For example, some companies calculate it based on a certain percentage of the original loan amount, while others base on a certain percentage of the unpaid principal. Consumers should contact their lending institution to understand the calculation method and check the actual amount of the early repayment fee.
The underlying principle of the Rule of 78 is also applicable to other loan tenors. For example, the sum of the number of monthly instalments is 300 for a 24-month loan (24 + 23 + 22 + 21 + 20 …+ 1 = 300). The interest for the first month would be 24/300 of the total interest; the interest of the second month would be 23/300 of the total interest, and so forth. The interest of the last month would be 1/300 of the total interest.
An example of the Rule of 78
| Loan amount: | $100,000 |
| Loan tenor: | 12 months |
| Monthly flat rate: | 0.5% |
| Monthly interest: | $100,000 x 0.5% = $500 |
| Monthly repayment amount: | ($100,000 ÷ 12 months) + $500 = $8,833.3 |
| Total interest: | $500 x 12 months = $6,000 |
| Interest repaid each month: | Total interest x remaining repayment instalments ÷ the sum of the number of monthly instalments (e.g. for 12 months = 12 + 11 + 10...+ 1 = 78) |
| Principal repaid each month: | Monthly repayment amount – Interest repaid each month |
| Interest repaid each month | Principal repaid each month | Monthly repayment amount | |
|---|---|---|---|
| The 1st month | $6,000 x 12 ÷ 78 = $923.1 | $7,910.2 | $8,833.3 |
| The 2nd month | $6,000 x 11 ÷ 78 = $846.2 | $7,987.1 | $8,833.3 |
| The 3rd month | $6,000 x 10 ÷ 78 = $769.2 | $8,064.1 | $8,833.3 |
| The 4th month | $6,000 x 9 ÷ 78 = $692.3 | $8,141.0 | $8,833.3 |
| The 5th month | $6,000 x 8 ÷ 78 = $615.4 | $8,217.9 | $8,833.3 |
| The 6th month | $6,000 x 7 ÷ 78 = $538.5 | $8,294.8 | $8,833.3 |
| The 7th month | $6,000 x 6 ÷ 78 = $461.5 | $8,371.8 | $8,833.3 |
| The 8th month | $6,000 x 5 ÷ 78 = $384.6 | $8,448.7 | $8,833.3 |
| The 9th month | $6,000 x 4 ÷ 78 = $307.7 | $8,525.6 | $8,833.3 |
| The 10th month | $6,000 x 3 ÷ 78 = $230.8 | $8,602.5 | $8,833.3 |
| The 11th month | $6,000 x 2 ÷ 78 = $153.8 | $8,679.5 | $8,833.3 |
| The 12th month | $6,000 x 1 ÷ 78 = $76.9 | $8,756.4 | $8,833.3 |
| Total $6,000 | $100,000 | $106,000 |
As calculated in the above table, if the remaining balances is settled before the 9th month, the debtor could save a total of $769.2 in interest (i.e. $307.7 + $230.8 + $153.8 + $76.9). If the early repayment fee is $1,000, early pay off would not save the debtor money. Instead, an additional $230.8 would have to be paid (i.e. $1,000 – $769.2).
12 Decemeber 2019
