“I purchased a stove using a hire purchase plan over 24 months. I got a lump sum in a partner draw and decided to pay it off early. To my surprise, I had to pay more than I had expected to in order to clear off the loan before the scheduled date.

“I think this was very unfair, in fact, I think I should have been rewarded for paying my loan in full before the due date. Can you explain how this is possible?”

When borrowing money it’s very important for consumers to be very clear about all the terms of their loan contract. As we’ve discussed in previous columns, the method of calculating a loan can make a big difference in the amount of your total interest and the monthly payments due.

What many borrowers are not aware of is that some loans contain prepayment clauses that can end up costing you a pretty penny if you decide to pay up earlier than contracted.

While most large financial institutions and lending agencies do not design their loans with prepayment penalties, you may be caught by this clause if you are borrowing from some micro lending firms and informal lenders.

If you examine the loan contact you may a see a reference to a refund or rebate of interest, which could be a sign that you’ll end up paying more if you pay early. If there’s an early payment charge, the lender could be calculating your payment based on the ‘Rule of the 78s’.

So what exactly is the Rule of 78s?

According to www.bankrate.com, the Rule of the 78s is a mathematical formula that was created in the days before modern calculators. It provided a quick way for lenders to estimate early payoff amounts on installment loans. Widely used in the 1920s and 1930s, it is relatively uncommon today; but it still can be found in institutions that cater to persons who have difficulties getting credit or wish for quick loan sources.

The Rule of 78s is also called the sum-of-the-digits method, as 78 is the sum of the digits one up to 12, which is the number of months in a year. It is calculated on a loan that has been pre-computed so that the borrower is contracted to pay back the principal plus the full amount of the interest owed over the life of the loan.

If you decide to pay a pre-computed loan off early and it the lending agency had included the Rule of 78s in your contract, then you will have to pay a penalty for being a good customer.

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Here’s the process of calculating your final payment changes on a loan using the Rule of 78s method: If you decide to pay of your 24 month pre-computed loan in 12 months instead, the lender will say that you are contracted to pay up two years of loan interest, not just one year. What the lender will then do is calculate your final payment including a rebate amount for the months of interest that you won’t pay because you choose to pay early.

The lender will then recalculate your previous payments, applying more of the payments to the pre-calculated interest portion and less to the principal amount. Because less of your money goes towards reducing your principal, the final amount you now owe will be higher than if you had continued along the original loan repayment scheme. In fact, the earlier you decide to pay off the loan and the higher the interest rate, the more it will cost you to prepay.

The bottom line is that the lender wants to ensure that whether you pay early or on time, most of the contracted income stream that was originally expected from the loan will still be in effect. Unfortunately for the consumer, it makes no difference in his pocket whether he pays early on as scheduled.

What can you do to avoid being caught by the Rule of 78s? Before signing, examine your loan contract carefully to see if it makes reference to prepayment penalties or rebate of interest. Also ask the lending agency if your interest is calculated on a reducing basis, where your interest charge goes down as you pay down the principal; or if you are obligated to pay the entire contracted interest amount.

If you realize that you’re already trapped in a loan that will charge penalties for paying off early, don’t bother to pay up before time. Keep making payments according your original schedule and invest the extra money instead.

Copyright © 2007 Cherryl Hanson Simpson. No reproduction without written consent.

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Originally published in The Daily Observer, July 19, 2007

Cherryl is a financial columnist, consultant and coach. See more of her work at www.financiallyfreenetwork.com and www.financiallysmartonline.com. Contact Cherry