How Banks Squeeze You – The Rule of 78

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Before considering to fully settle your personal loan or hire purchase, learn about The Rule of 78. The Rule of 78 is an interest-principal computation method which make it costly to those who plan to pay off their balance ahead of schedule.

The Rule of 78 is a quietly-kept secret from banks that not many people are aware of. It’s implemented to always benefit lenders aka, the banks. Hence, it is to their advantage that many people can barely understand it. So, what exactly is this and how does it affect us, consumers?

The Rule of 78 functions by using an arithmetic formula so that earlier instalments include a larger interest under a loan. In contrast, reducing balance as the name implies, is where the interest paid each month is based on the principal balance which decreases as you pay more.

Many consumers have demonstrated their shock when they find out their personal loans or hire purchases are based on the Rule of 78. Some go as far as saying that they were duped without their knowledge. The realisation normally comes when one wants to settle their loans early but instead find out that instead of paying most of their principal, more of it went to pay the higher interest in the beginning.

The Maths of The Rule of 78

Based on the concept of a 12-month loan, 78 comes from the sum of the digits of those 12 months added together. 

1 + 2 + 3 + 4 + 5  + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78

So, what happens is that the interest allocated is in reverse order according to fractions. In Month 1, you’d pay 12/78 of the interest, Month 2, 11/78 of the interest and so on. In the end, the borrower always pays more interest up front.

Here is an example, assuming you took a personal loan of RM10,000 with an interest rate of 12% per year for one year, you will need to pay RM1,200 as interest (RM10,000 + 12%). So over the course of your loan tenure, you are expected to pay a total of RM11,200 or RM933.33 (RM11,200 / 12) of 12 equal monthly instalments.

The instalment amount of RM933.33 contains an interest portion (which the bank earns) and a principal portion (to “offset” the loan amount). To compute how Rule of 78 allocates the interest and principal portions, the following table illustrates:

The Rule of 78 interest and principal allocation method over 12 months.
The Rule of 78 interest and principal allocation method over 12 months.

Using the illustration above, for example, if you want to redeem your loan after month-6, you would still need to pay RM5,276.92 (more than half of the RM10,000 principal even though you have already paid 6 of 12 instalments) but the bank would have already earned almost 69% of the total interest.

This is why consumers feel deceived as they are not told upright and given a choice to decide. The differences in interest rates may seem small but they do have a big impact on the total interest payable over the entire course of the loan tenure.

The good news is, Rule of 78 only affects you if you decide to settle your loan earlier.

What Should I Do Then?

Asian couple sitting on a couch looking at bills and statements in front of a laptop together.

Unfortunately in Malaysia, most (if not all) financial institutions are using this method to allocate precomputed interest/ profit charges for personal loans and hire purchase. It is unfair to consumers because it penalises anyone who pays off a loan early. This method is so controversial that it was outlawed in the U.S. for loans longer than 61 months since 1992 and the U.K. since 2005.

If you’re already in the middle of a loan using the Rule of 78, continue to pay according to the predetermined schedule unless it makes sense based on your unique financial situation. It’s better to use the spare cash for your mortgages or invest somewhere like the KWSP Self Contribution. The annual return for KWSP averaged around 6.15% from 2011-2020. It’s still vastly superior compared to being penalised for paying off a loan early!

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