Rule Of 78 Finance Lease

The Rule of 78, also known as the "sum of the digits" method, is a way to calculate interest refunds on a finance lease when it's paid off early. While less common today, understanding it is helpful because it historically impacted early lease terminations and occasionally still surfaces in older contracts.

The core principle is that it front-loads interest charges. This means you pay more interest in the early stages of the lease and less towards the end. The name "Rule of 78" comes from a 12-month lease (12 + 11 + 10 + ... + 1 = 78). For any 'n' month lease, the sum is calculated as n(n+1)/2. This sum represents the denominator in the refund calculation.

How it Works:

1. Calculate the Total Interest: This is the difference between the total lease payments and the original cost of the asset being leased.
2. Determine the Sum of the Digits: For example, a 12-month lease has a sum of 78. A 24-month lease would have a sum of 300 (24 * 25 / 2).
3. Calculate the Interest Earned: If you pay off a 12-month lease after 6 months, you need to figure out how much interest the lessor has already earned. This is calculated by adding the remaining months' digits (6 + 5 + 4 + 3 + 2 + 1 = 21) and dividing it by the sum of the digits (78). Then, multiply this fraction by the total interest. This gives the proportion of total interest that hasn't been earned. Subtract the result from total interest to find the interest earned.
4. Calculate the Interest Refund: This is the total interest minus the interest earned by the lessor. This refund is subtracted from the remaining balance of the lease.

Formula:

Interest Refund = Total Interest * (Number of Remaining Months x (Number of Remaining Months + 1) / 2) / (Total Number of Months x (Total Number of Months + 1) / 2)

Why the Front-Loading?

The rationale behind the Rule of 78 was to compensate the lessor for their initial costs and risk associated with the lease. They incur expenses like acquisition costs and the initial depreciation of the asset upfront. By front-loading the interest, they ensure a greater return, especially if the lease is terminated early. It also serves as a disincentive for early termination.

Criticisms:

The Rule of 78 is often criticized for being unfair to the lessee. It results in a smaller interest refund compared to other methods like the actuarial method, which calculates interest based on the outstanding principal balance. Due to these concerns, many jurisdictions have restricted or prohibited its use in consumer financing. However, it might still be legal in commercial leases, depending on local regulations.

Modern Relevance:

While less prevalent in modern finance leases, it's crucial to check your lease agreement. Older leases or leases in certain jurisdictions might still employ the Rule of 78. If your lease agreement mentions it, understand its implications before signing. If you're considering early termination, carefully calculate the refund to assess the true cost.