The Rule of 78 and How It Impacts Your Car Loan Settlements

Meet Mr. Tan. 

Mr. Tan bought a brand new RM 100,000 car and financed it with a 10% deposit of RM 10,000 and a RM 90,000 car loan where his loan tenure is 5 years and his flat interest rate is 3% per year. Hence, Tan’s monthly car loan installment is RM 1,725, which is calculated as follows:

Tan has been paying his car loan installments promptly without fail for 3 years. 

Then, he wishes to settle his car loan in full as he thought that he would save as much as 2 years worth of interest costs totalling RM 5,400. 

Tan figured that he had already paid off RM 54,000 in loan principal and thus, is expecting to pay RM 36,000 to settle his car loan in full. 

So, off he goes to the bank to visit his banker. 

To his dismay, his banker told Tan that he needs to pay RM 39,186.89, if he likes to settle his car loan in full. Instead of saving RM 5,400, Tan would only manage to save RM 2,213.11 in interest costs, a far cry from what he had expected. 

Why is There a Difference? 

The answer lies in understanding the Rule of 78. 

With it, lenders will earn higher interests from the earlier part of the scheduled loan repayments made by their borrowers and would be earning lesser interest towards the end of their scheduled loan repayments. 

In other words, Tan will pay more interest costs when he begins to make his car loan installment payments and will gradually pay lesser interest costs over time as he approaches towards the end of his car loan installments. 

What is Mr. Tan Thinking? 

Tan thought he is paying RM 2,700 in interest costs a year, which amounts to as much as RM 225 a month. He thought that his interest cost of RM 225 a month will remain constant throughout his loan installment period of 5 years. 

How the Bank Calculates Their Interest Income? 

But, in reality, lenders will use the Rule of 78 when computing their interests to be earned from disbursing car loans to their borrowers. 

Before I move onto explaining Tan’s figures, let me begin by first expounding on the Rule of 78 with an easier example below: 

For instance, you obtained a RM 10,000 loan where its loan tenure is for 1 Year. You incur a 5% flat interest rate and pay back the loan in 12 equal installments. 

Thus, you will pay RM 500 in interest cost. 

So, the amount of interest cost you will pay for each monthly installment would be calculated as follows: 

Step 1: Calculate the Total Digits of Installments 

First, the lender will compute the summation of your total digits of installments of the loan. So, for a 1-Year Loan, it is calculated as follows: 

Total Digits of Installments (1-Year Loan) 

= 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 

= 78 

Meanwhile, as for a 2-Year Loan, it is calculated as follows:

Total Digits of Installments (2-Year Loan) 

= 1 + 2 + 3 + … + 22 + 23 + 24

= 300

Step 2: Weighs Interest Payments in Reverse Order

Second, the lender will place greater weightage of interest payable by reversing the order of installments as illustrated below: 

Interest Payable @ Month 1 (1-Year Loan) 

= ((Total Installments – x Month + 1) / 78) x Total Interest Cost 

= ((12 – 1 + 1) / 78 x RM 500

= (12/78) x RM 500

= RM 76.92

As you can see, it is unlike a method where you conveniently even out the costs of your interest, which is RM 500, equally over 12 months. Refer to the table as shown below:

Of which, we learnt that: 

1. The interest cost payable for both methods are the same at RM 500. 

2. But, with the Rule of 78, the lender would have earned 73% of its interests at the sixth month of the scheduled loan repayments. 

Mr. Tan Settled 84% of his Total Interest Cost at Year 3

And … he didn’t know about it. 

I prepared a simple template to calculate the monthly interest cost payable by Mr. Tan to the bank for his 5-year car loan. 

Link: Calculator – Car Loan Settlement

Of which, Mr. Tan would have paid off:

After 3 years, Mr. Tan paid off RM 50,813.11 in loan principal and RM 11,286.89 in interest payments (83.6% of total interest costs that he would bear if he pays off all his loan as scheduled at the end of 5 years). 

Therefore, Mr. Tan needs to pay RM 39,186.89 to settle his car loan in full. 

Payment Needed to Settle His Car Loan: 

= Loan Principal – Principal Paid

= RM 90,000.00 – RM 50,813.11

= RM 39,186.89

Mr. Tan would save RM 2,213.11 on interest payments. 

Interest Payments Saved: 

= Year 4 Interest + Year 5 Interest 

= RM 1,637.70 + RM 575.41

= RM 2,213.11

If I’m Mr. Tan … 

Would I settle my car loan in full earlier at Year 3? 

The answer lies in whether or not I could better use the RM 39,186.89 I have in my bank account to generate better yields than 3% a year. Hence, this would be highly dependent on my age, financial status, and investment skills. These are a number of factors that will influence what and how I would invest my money. 

Personally, they could be used as capital to invest in stocks or properties. 

There are so many options available and you don’t need to just use that capital to pay off the loan. Therefore, I’ll like to encourage you to explore your options, read some books and talk to trustworthy people before deciding on what is the best for your financial situation.