Tuesday, December 2, 2014

Rule of 78 in Hire Purchase Loan

Henry Tan | 2:04 PM |
Apart from accounting/finance/bank folks, most of us may not know Rule of 78.
Rule of 78 is the allocation of interest charge on a loan throughout its payment periods.
It is commonly used to calculate the interest rebate or redemption sum (early settlement).
Rule of 78 applies in Hire Purchase Loan or more commonly known as car loan.

Let's start with the Rule of 78

As usual, giving example is the best illustration.
Assumptions:
Hire Purchase Loan/Car Loan = 25,000
Repayment Period = 1 year = 12 months
Interest Rate = 3% p.a

Yes, it is a direct calculation for the interest of car loan:
25,000 X 1 X 3% = 750
Hence, total car loan will be principal + interest:
25,000 + 750 = 25,750
So, monthly installment will be:
25,750 / 12 = 2,146

But, do you know what's the proportion that paid to interest?
This is where Rule of 78 comes into the picture!

Rule of 78 Hire Purchase Loan Car Loan

Which explains why it is call Rule of 78!

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

Of course, usually the repayment period would not be that short.
The above case is just to show the "78" in Rule of 78.
So next, same car, but with longer repayment period, let's say 7 years!

Again, it is a direct calculation for the interest of car loan:
25,000 X 7 X 3% = 5,250
Hence, total car loan will be principal + interest:
25,000 + 5,750 = 30,250
So, monthly installment will be:
30,250 / 84 = 360

Rule of 78 Hire Purchase Loan Car Loan

In this case, there's no longer the number 78 in Rule of 78!
But calculation still the same, except with 7 years/84months you will get 3570.
So how to get 3,570?

So the interest trend in Rule of 78:

The amount of interest is highest in the beginning 
and reduces over the loan period.

How does it affects me?
Well, it doesn't affect unless you are going for early settlement or repayment.
Hence, it is important to know which debt to settle first when you got a lump sum.
Subsequently, you could also check with your financial planner!
Looking for a financial planner? Contact me!

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2 comments:

  1. Long ago, if you buy cash, they would give you a cheaper price. These days, no more...exactly the same - they want you to take a loan...so they can split the commission from the bank - the car dealer people and the bank people. Terrible!!!

    ReplyDelete
    Replies
    1. yes you are right! and even worse is that nowadays people are more towards instant gratification, and with the promotion and "seduction" from bank installment, people are lured into buying it using the future money they have yet to earn.

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