## The Rule of 78

I’ve a lot of hits on my piece Any Magic Trick is Easy Once You Know the Secret. I want to take a second and thank everyone who read it and especially those who clicked like! In about the middle of it, I challenged the readers with this indented paragraph…

Here’s something you should try. Look up the “Rule of 78” it’s an accounting tool that they use to calculate amortized loan payments (Yes, that’s your home mortgage and car loans). Then walk into your local banks and mortgage lenders and ask the person who handles these types of loans what it is… I’ll tell you right now, about 95% of them won’t have a clue what you’re talking about, 4% of the remaining will heard of it but have no idea what it is, though they’ll think it’s used in loans. The remaining 1% will actually know.

Because of the importance that the Rule of 78 plays in mortgage and car loans I want to go ahead and explain what is and how it works. Originally it was “created” before there were computers as way to easily calculate a loan by providing a formula that allows the borrower to make consistent payments throughout the duration of the loan.  At the time it made life easier both for the borrower and the lender who didn’t have as much work to do recalculating the payments every year to adjust the payment amount factoring in the reduction of principal and new interest amount owed. Which is what they’d have to do if they used simple interest on loans that have a long duration of repayment.

The Rule of 78 is also the reason why though you pay 28% or more on your credit cards and yet can qualify for a mortgage rate of around 6%…. Did you ever wonder about that?

I’ve included the Wikipedia link that explains the actual calculation process. Here I’m just going to give a brief example of how it works against you. I’m going keep this on the super simple explanation because I don’t want this post to be longer than the post I mention it in. So without further ado….

In basic terms this is how it works. Lets say your mortgage payment is \$1000.00 a month for 30 years. Your payment book shows your 1st payment is \$1000.00 dollars and so is your last payment. Where 78’s (I’m using cool slang here ;)) come in play on this, the actual amount you borrowed and interest rate are not important since we know that your total payment due each and every month is \$1000.00 (if this hasn’t raised a red flag yet, it should have generated a serious HUH!?!?!?!!!!).

78’s effect how the payment is disbursed between what is paid towards the principal and what is paid towards the interest. So, once again keeping it simple this is what they do…

1st Payment

\$1000.00= Interest paid \$780.00 + principal paid \$220.00

Last payment after 30 years.

\$1000.00= Interest paid \$220.00 + Principal paid \$780.00

During the duration of the loan the interest is paid off first and the principal second with the percentages gradually changing over the years so you pay off most of the principal at the end of the loan. Why should this be a reason for concern? For several very important reasons.

1. You pay significantly more interest, especially when the loan duration goes longer e.i. 15 year loan not a lot of interest paid relative to the amount paid on a 30 year loan.
2. On a 30 year loan you pay the bank the amount it risked giving you the mortgage in 10 years. For example you borrow \$100,000.00 you will pay about that much in 10 years and the remaining 20 years of the loan is paid towards the interest. So if you default on your last payment of the loan the bank can still and mostly likely will foreclose on you. Even though their risk (i.e. the \$100,000.00) was paid back to them 239 payments ago and their only really out the interest.
3. \$100,000.00 loan for 30 years turns into \$600,000.00 paid to the bank and your home has to exceed a value of \$600,000.00 for you to be able to have any return on your investment in the property. Would you buy stocks on margin that had little or no ability to grow in value exceeding what you paid for them over thirty years? Honestly?

If you have kids and are paying a mortgage, they hit college about the time your 20 years into your mortgage (for some less, others more) with another 10 years to go. Think about that while your planning on ways to pay for their college education. At the 20 year mark the bank is 10 years into the gravy with 10 more to go. The modern computer age calculating loan interest is as easy as pushing a button so having a mortgage that slowly drops in monthly payments as the loan matures is easy, very easy. Honestly, who wouldn’t be happy to enter their kids college years with a mortgage payment lower than it was when they 1st took the loan, without having to move to a smaller house or pay more money so the bank will lower the monthly payment on the interest of the money borrowed and already repaid.

If I loan you \$100.00 and make you pay me \$600.00 to repay the loan they call it Usury

If a bank loans you \$100,000.00 and makes you pay them \$600,000.00 to repay the loan they call it  Mortgage.

Sadly only one of these transactions is illegal…

The banks don’t want your home just the income they can generate selling it to you or anyone else. All they need you to is mow the lawn and wash the windows until you can’t pay anymore any they sell it to someone new and the whole process starts over again… (Image from FreeStockPhotos.com)

Oh, with car loans the interest paid using 78’s (my last chance for cool slang! ;)) the short terms of the loan duration brings the amount of interest more in-line with simple interest loans. This is because the loans of 20+ years were rare when the banks started using 78’s.

Attending Triton College. Studying Emergency Services Management & Criminal Justice. Currently employed @ MPPD & Aflac. After 30 years out of school I'm back in College and having a Blast!
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### 6 Responses to The Rule of 78

1. I sorta feel lucky that I never had enough money to move out of my apartment. Even though I lament the lack of an art studio, thank heavens I never saddled myself with a 30 -year mortgage. Talk about pouring money into a hole in the ocean. I cannot then imagine trying to downsize to a retirement community just as that home is finally one’s own! It doesn’t make any sense at all. But I don’t think it was supposed to make sense…just to make the bankers a lot of money. Who came up with this scheme and why did we fall for it? Just plain old greed to own a home at any cost, literally? Anyhow, Grazie mille for the clear and easy-to-grasp explanation. I may still understand little, but you can at least rest assured that it has nothing to do with your attempt to educate! Write on!

• MartyW47 says:

Thanks very much for your comments Pam! Like many things in life something that was suppose to make life easier for everyone became corrupted. 78 first came into use during the time before computers, adding machines and calculators. During the time when Americans saved to make purchases not buying on credit. The corruption part truly happened when President Reagan and his cronies removed the limitation that allowed banks and mortgage companies to only loan against 28 to 30% of a persons income. When they lifted that limit it caused 2 things to happen home values shot up quickly and loans were being made as high as 100% of persons income causing home values to continue to soar.

2. Argh, Reagan and his cronies did a whole heck of a lot of things that changed everything! Then came the Bushes, and Clinton frankly didn’t help much, what with the Republicans in power, so the whole system has gone to pot. Greed is the name of the game, as it always has been.

• MartyW47 says:

Yea, sadly it was not intended that way, at least in my opinion. I do believe if the founding father were alive today we’d label them extremists and attempt to stifle their beliefs. I hope to live long enough for Reagan and the Bushes to get labeled for what they really are. Clinton on the hand actually did do a lot of good it’s just George W & the guys pulling his strings undid it as quickly as they could..

3. Maybe I’m a starry-eyed blindwoman, but I still believe that if Kennedy, JF, had been allowed to live, the world would have been a very, very different place…Well, needless to say! But he wanted such a different world from the one Johnson gave us (escalating Vietnam) and then Nixon proceeded to destroy, despite what we are told now. Just listen to his speeches. At least if you listen to those speeches, and I for one believe he meant them, if the world were 1% of the way he wanted it to have become…well, “like I said” — a world without war, poverty, a world where one thinks of others and country before self…I think people believe that Kennedy could not have been as good a man as he was simply because he was a womanizer and came from wealth, but it has been done before. You don’t have to lose it all to see that “having it all” is grossly and grotesquely unfair.

• MartyW47 says:

I hear Pam, I agree the world would have been a very different place had both Kennedy’s survived. I do credit Johnson for trying to keep to what he believed JFK wanted. In fact he’s the reason that we no longer vote individually for President and Vice President. (Partly because He tried to follow JFK’s ideas raising the ire of his fellow republicans and partly because both side realized they didn’t want the possibility of a shift in the political party controlling the White House in the event the President was assassinated) I always find sex issues and politics funny as hell. The party that claims Family Values has had infinitely more embarrassing incidents in that area than anyone or any other party. Thanks for the great comments!