Tom Kelly: Old consumer loan method applied to home mortgage

Refinancing continues to be a hot topic. Many homeowners who are planning to stay in their homes for the long term are trying to find ways to lock in low interest rates.

Some borrowers are running into qualification issues for the first time in their lives. They are discovering they do not have enough income to refinance the home they have occupied the past several years – even though the new loan comes with a lower interest rate than their current loan. Loan representatives are reporting their biggest challenge has been explaining to existing customers they “can’t qualify for a mortgage under 5 percent.”

Others are upset because they are facing prepayment penalties on existing mortgages even though they have a flawless payment history and a terrific credit score.

A different wrinkle surfaced recently when a reader brought up an issue we have not explored for years. She had purchased a home with the proceeds from her previous home plus a small balance financed by the owner. She had planned to pay the small balance off within three years and save some interest money but was shocked to discover the loan structure – “the rule of 78s” – did not allow any savings.

For many years, lenders used the rule of 78s for personal loans and auto loans because it’s quick and simple to apply to a prepaid loan. The rule of 78s is only a problem for someone who decides to pay off a loan before the agreed upon term of the loan. In this case, the owner of the home was a retired car dealer and opted to employ the loan method on the woman’s loan.

When lenders use the rule of 78s, they distribute the total finance charge over all payments but charge more interest early in the loan term and less later, compared with other methods such as simple interest. Mortgage interest is also front-loaded but a prepayment penalty is not automatically built into the payment system like it is with the rule of 78s.

The rule of 78s, also called the sum of digits method, gets its name because the sum of digits 1 through 12, the months in a one-year loan, is 78.

Here’s how the rule of 78s works for a 12-month loan: You pay 12/78 of the total finance charge the first month, 11/78 the second month, 10/78 the third month, and so on. The rule of 78s applies the same way for long-term loans. For example, a 24-month loan, in which the sum of the digits for months one through 24 is 300, would have a first month’s interest of 24/300, second month’s interest of 23/300, and 22/300 for the third month. Interest on a 36-month loan would be broken into 666 parts.

In contrast, credit unions traditionally charge simple interest on a declining balance. This method assesses interest only for the period that you use the money. With both loan calculation methods, each monthly payment is part principal and part interest. Again, the rule of 78s assigns more interest to early payments.

Why should you care? It can cost you if you’re thinking about paying off – or refinancing – a rule of 78s loan before it matures.

In the end, if the loan is not prepaid and held for the full term, there is no loss to the borrower whether the loan is set up for the rule of 78s or simple interest. The borrower gets snagged with the rule of 78s because it accelerates the interest recognition by assuming you will pay the total contracted interest, which favors the lender if you prepay. Therefore, it’s a hidden prepayment penalty.

Not sure if your loan uses the rule of 78s? Look at your Truth in Lending disclosure. If you see a phrase like “you will not be entitled to any rebate of part of the finance charge if you prepay,” ask the lender (or private party) if it computes interest using the rule of 78s.

A private party probably will not supply you with a Truth in Lending sheet. While there’s only a remote chance you cannot prepay the balance without a penalty, always ask and require the party to discuss the prepayment possibilities.