How Rule of 78 works in Car Loans?

[Dennis Ng]

Below is my answer to a reader who wrote to Straits Times in March 2005 on whether it makes sense for him to fully redeem his car loan (flat rate of 2.6%) after paying 27 months of instalments on a 7 year car loan (84 months altogether).

In my answer I also explain how Rule of 78 works in car loans.

Based on our calculations, Roger is charged a flat rate of 2.6% per annum on the car loan. However, the effective interest rate ie. the actual interest cost of your original loan works out to 4.87% instead. Like Roger, many consumers are unaware that the effective interest rate of a car loan is much higher than the flat rate quoted by your bank or finance company. A ?flat rate? means the bank charges interest on the full loan for the entire period, without taking into account the progressive reduction of the loan. You should ask your bank/finance company for the effective interest rate (EIR) if it is not stated in your loan agreement.

The total amount payable to fully redeem the loan now (assuming no penalty) works out to $87,571.56. By paying off the loan now, based on the current loan outstanding, Roger effectively gets to ?avoid paying? (or save) the effective interest rate on the remaining loan which works out to 4.69%. So if Roger has $87,571.56 on hand, by paying off the loan, he effectively gains 4.69% compounded annual returns. Unless Roger is confident that by investing for the same time period (remaining 57 months of loan tenor) and getting annual compounded returns higher than that of the loan interest of 4.69% per annum, otherwise, Roger might consider paying off the car loan instead.

Of course before making the final decision, Roger should consider other factors such as is there any penalty payable on redeeming the car loan now? Furthermore, Roger should also ensure that after paying off the loan, he still has sufficient cash on hand to serve as an emergency fund to meet any contingencies that might arise. Typically, it is prudent for an individual to have sufficient cash to meet at least 3 to 6 months of their expenses to serve as an emergency fund.

Interest rate Flat rate of 2.6% per annum
Original Loan $122,000 (a)
Total interest for 7 years ($122,000 x 2.6% x 7 years) $22,204 (b)
Principal + interest $144,204 (a) + (b)
Instalments paid Monthly instalment = $144,204 / 84
= $1,716.72
Total amount paid after 27 monthly instalments = $1,716.72 x 27
= $46,351.44 ?
Rebate of Unearned Interest using Rule of 78* $10,281 (d)
Total amount payable to fully redeem the car loan (assuming no penalty) (a) + (b) ? (c) ? (d) = $87,571.56

Note: Forumula used for the Rule of 78

Rebate of unearned interest = [n (n+1)]/[N(N+1)] x total interest for loan period

= [57(57+1)]/[84(84+1)] x $22,204

= $10,281

Above comments provided by Dennis Ng, a Certified Financial PlannerCM who regularly speaks and writes on financial planning issues. Dennis can be reached at 6339 9255 or info@HousingLoanSG.com

[Dennis Ng]

Hi Mr Dennis ,

1) Are you able to join us how to calculate effective interest rate ?
if given flat rate only

2) Can you give other type of loan that used flat instead of effective interest rate?

3) What is the defination of effective interest rate ?

Applemei

My comments:
Dear tyumei,
1. you would need a financial calculator or financial spreadsheet to calculate effective interest rate. Typically, the effective interest rate is almost double of the flat rate. eg. 3% flat rate, effective rate is about 6%.

2. some business loans banks also use flat rate.

3. effective interestive rate is the "actual" interest cost of your loan. It should be expressed on a per annum basis. eg. Housing Loan interest rate 3% is also the effective interest rate since the principal is "reduced" monthly and you're being charged on the reduced principal each month unlike car loan where you're being charged a flat rate on the original principal loan eg. $50,000 and not on reduced principal as you pay your monthly instalments.

You can call us at 6339 9255 or email us at info@HousingLoanSG.com for an unbiased analysis of ALL Housing Loans in Singapore and Australia!