THE VIRGINIAN-PILOT
Copyright (c) 1997, Landmark Communications, Inc.
DATE: Thursday, February 13, 1997 TAG: 9702130004
SECTION: FRONT PAGE: A21 EDITION: FINAL
TYPE: Opinion
SOURCE: Patrick Lackey
LENGTH: 101 lines
A method many lenders use to calculate interest when consumers repay loans ahead of schedule is sneaky, irrational and despicable.
What's more, I don't like it.
The method is outlawed in 17 states, and this should have been the year that the Virginia General Assembly drove a stake through its evil heart.
Instead, a bill to abolish the method died for want of a second in the House of Delegates' Corporations, Insurance and Banking Committee.
The method to filch money from consumers' pockets survives for another year, and Virginia legislators have proved once again that they mean it when they say they are pro-business.
Virginia consumers beware.
The method I speak of is called the Rule of 78s. A retired lender told me once that he had processed 50,000 loans in 21 years and met but three people who understood the Rule. All three were government economists.
As chance would have it, I understand the evil Rule of 78s. About 20 years ago in Iowa I wrote a string of stories about it that led that state's legislature to ban its use. Back then, I was young and idealistic. I used to lie awake nights hating the Rule of 78s.
Today, in cynical middle age, I'm only mildly angry and certainly unsurprised that the Rule's use is still permitted in Virginia. The wonder to me, in fact, is that the Virginia General Assembly in recent years has reined in its use, somewhat.
What the Rule of 78s does is pack extra interest charges into the early months of a loan, so there's less interest to escape paying when the loan is repaid early, as when a car or boat is traded in before the loan on it is paid off.
On a 12-year, or 144-month loan, for example, the borrower, according to the Rule of 78s, pays 144 times as much interest in the first month as the last, 143 times as much interest in the second month as the last, and so on.
In that way, the Rule packs so much interest into the front of long loans that, in the past, many Virginia boat buyers or second-mortgage borrowers would go to repay loans after a few years of monthly payments and discover to their horror that they owed more than the amount they'd borrowed.
``How can that be?'' they wondered loudly.
According to the Rule of 78s, all of the hundreds or thousands of dollars they'd repaid in the early months counted as interest, and in fact they owed still more interest. So much interest was packed in the front part of long loans that it took some borrowers years of monthly payments before they began whittling away at the principal.
This went on for decades in Virginia, with legislators able to bear consumers' misery. In 1991, however, the General Assembly limited the Rules' use to loans of 60 months or fewer. That was a significant restriction, because the Rule of 78s is less blood-thirsty on shorter loans. For example, never on a loan of 60 or fewer months will a borrower's entire monthly payment go for interest. Never on a loan of 60 or fewer months will a borrower end up owing more than he borrowed.
The borrower who repays a shorter loan early still gets ripped off, without ever knowing it, but not as badly as on longer loans.
Here are two short-loan examples provided by Jean Ann Fox, until recently the president and volunteer lobbyist for the Virginia Citizens Consumer Council:
If a four-year, $15,000 personal loan at an annual rate of 18 percent is repaid after 18 months, the borrower is charged an extra $323 in interest when the Rule of 78s is used.
If any three-year loan at 18 percent is repaid at six months, the actual interest rate charged will be 19.5 percent when the Rule of 78s is used.
The Virginia Code requires that loan contracts calling for the Rule of 78s contain this language in boldface: ``Notice: If you pay this loan in full before its due date, the amount of interest you pay will be greater than the amount of interest you would pay for a simple interest loan of the same principal amount.''
Do you understand that?
Odds are long that a borrower refinancing a loan will never know that he has paid extra interest because the Rule of 78s is used. The Virginia Code does not require lenders to reveal how much extra interest was collected as a result of the Rule of 78s.
The Rule of 78s is used only when loans are repaid early, but such repayments are common. In 1991, for example, one Virginia bank said 40 percent of its consumer loans were repaid early.
This year, the Virginia Bankers Association defended the Rule of 78s before the House banking committee and naturally prevailed. Bankers argued, among other things, that lower interest rates can be charged on consumer loans because the Rule of 78s is used in cases of early repayment.
Frankly, I'd be amazed if a study showed banks that use the Rule of 78s charge lower interest rates than banks that don't use it.
But if that's true and lenders insist on charging penalties for early repayment, they should do so in an open manner that borrowers understand.
The Virginia General Assembly did take a huge step against the Rule of 78s in 1995 when it prohibited small-loan companies from using the Rule. That was a hollow victory for consumers, however, because it was part of a deal that freed small-loan companies to charge interest rates as high as they pleased. What consumers gained on the one hand, they more than lost on the other.
So, Virginia consumers beware. If you don't want to get burned by the Rule of 78s, read the small print of the loan contract to see if it contains the boldface notice printed above.
Incidentally, Virginia credit unions never were allowed to use the Rule of 78s, and the big-three auto-finance companies - GMAC, Ford and Chrysler Credit - have voluntarily stopped using the dreaded Rule. Probably the majority of Virginia banks no longer use it.
The Rule of 78s stinks. It's in retreat. In Virginia, however, that retreat will be slow, perhaps too slow for the eye to detect.