The Rule of 78 – What is it and why does it matter?

When it comes to finance, there are a lot of terms, topics, rulings, issues and factors to take in, especially in relation to commercial finance. At Jade Finance, we endeavour to educate and inform our customers as much as possible to ensure they are well-informed.

One of the topics which we’ve been asked about recently is The Rule of 78. Customers are wondering what it is and why should it matter to them?

In this article in our educational series, we tackling the topic of The Rule of 78 – in as simplistic form as we can. The purpose of this article is to inform, not provide financial guidance. Any decisions or explanations around how the Rule of 78 may affect your individual financial situation should be discussed with your financial advisor.

ATO Ruling

As with many issues around finance, especially when they relate to taxation, the Australian Taxation Office (ATO) is always a good point of reference. They have a section on The Rule of 78 which you are welcome to deep dive into yourself.

The Rule of 78, also known as Rule 78 and Rule of 78s, is one of several methods of calculating and apportioning the interest charged on fixed term commercial loans. It doesn’t apply to all loan types.

The ATO Taxation Ruling TR 93/16 covers the detail around when it is appropriate to use Rule 78 but not the tax deductibility considerations. That is covered in another Ruling.

The ATO states that where Rule 78 is applied, it must be consistently done over the loan term.

Methods for Apportioning and Calculating Interest

Rule 78 is one of a few methods that lenders use to calculate interest.

In addition to the Rule of 78, these methods include:-

The Flat Rate: the total of the interest payable on the total loan amount is calculated and apportioned equally to the number of repayments. This means that the interest component of each repayment is the same and the principal is also being reduced with each payment.

The Actuarial Method: with each repayment, the loan balance is multiplied by the rate of interest. The result being that interest component of each repayment will be decreasing over the loan term and a greater amount of the principal is repaid each month.

The Rule of 78: Explainer

  • Rule 78 utilises an arithmetic progression to calculate the interest and apportions. The outcome is that more of the interest is apportioned to the first part or early repayments than the later repayments. As such, the borrower pays a larger part of the total interest earlier in the term.
  • The loan amount or principal is reduced at a slower rate because more of the repayment is being offset to the total interest owed.
  • When the borrower pays all repayments and any balloon or residual owed, the amount paid in total, including the interest, is the same for all methods.
  • If the borrower elects to pay out the loan before the end of the loan term, a greater amount may still be owing that expected as the principal has been paid down slower. More of the repayments have been offset to the interest than the principal.
  • Statements which display the interest and principal may be provided by some lenders.

Outcomes and Impacts

Why Rule 78 matters to some borrowers is that it may impact the amount of interest which is tax deductible at any particular stage of the loan term. It may also have an impact if the borrower chooses to pay out the loan early.

However, be assure that when Jade Finance provide you with a quote, you will be advised of the interest rate and the repayments will include the total interest and any fees and charges applied by the lender.

The total interest payable on a loan is the same under each method.

The Rule of 78 is a rather technical issue, but we hope this explainer has been helped you understand what it involves.

If you have any questions you’d like us to address in our educational articles, please contact us.

To discuss commercial finance on motor vehicles, trucks, business equipment, marine vessels and general business finance, please contact Jade Finance 1300 000 008 for a confidential and obligation free conversation.