Rule of 78s - the pitfall of credit rebates.

I get the monthly Lifestyle magazine courtesy of the NTUC, which I hardly ever take out of its plastic wrapping.  It's supposed to be Singapore's Largest Circulating Magazine, whatever that means. I always know it as a booklet full of adverts instead of being a serious 'lifestyle' periodical.

But once in a while I do rip the packaging and flip through the pages. Something caught my eye in this month's issue. An article called "Small weekly payments" in their MoneySENSE feature.

In the article, the author was relating his experience of buying a HD TV on credit installments. The TV cost $6,500 but was being offered at $5,200, (saving $1,300!). To avoid the heavy upfront outlay, the writer opted for the installment plan of paying only $44.90 a week. With a tinge of regret and in hindsight, the writer later calculated that in the end he would be paying $8,620 which was 33% more than the usual price or 66% more than the offer price.

I took an interest in the article because I previously worked for a major retailer who did precisely this kind of transaction, offering credit installments on purchases.

One thing that most customers don't realise, or are not informed of, is that the repayment scheme is based on what is called the Rule of 78s.  This is what most car loan companies, banks and finance companies use in calculating interest rebates.
I will not even try to explain it to you!

You'll probably be lost within the 1st sentence of the complicated formula. Look up Rule of 78s in Wikipedia if you really want a background on calculating your loan payments. 

In a very simplistic nutshell explanation, it means that you pay the interest on your loan before your payments start reducing the principal amount.   That's why you always lose out when you decide to foreclose the loan earlier than the term allows. There is hardly any interest rebate left to take back. What's left of your outstanding loan is most of the principal sum because you have only been repaying the interest portion of your loan first.

A simple example is your credit card bills. If you just pay the minimum monthly sum each month, you will realise that you are just paying interest for that month and there is hardly a reduction of the credit amount used.

Caveat emptor.