Unfair car loan practices - Malaysian financial taskforce proposes Rule of 78 method to be made illegal

• Consumer Credit Oversight Board Task Force (CCOB) is proposing to make it illegal for banks to use Rule of 78 method to calculate interest payments for car loans
• Rule of 78 calculates interest based on borrowed sum, not balance owed
• Rule of 78 method used by Malaysian banks is illegal in UK, Australia, New Zealand. In USA, it is limited only to 5 years or less tenures.

Car loans, specifically hire purchase, are the second highest cause of bankruptcy among Malaysians, according to a report by the Malaysian Department of Insolvency (MDI) earlier this year.

In the last 5 years, more Malaysians (14.39 percent) became bankrupt by taking out 9-year loans to buy cars they can’t afford, than people who took out loans for businesses (14.12 percent).

Also read: Car loans are the second highest cause of bankruptcy among Malaysians

Did you know that the Rule of 78 method used by local banks to calculate interest payments for fixed interest rate car loans is illegal in the UK, Australia, and New Zealand? In the US, the Rule of 78 method is only allowed for loan tenures of 5 years or less, and the US is hardly a model country for financial prudence.

Singapore and Hong Kong allow Rule of 78 but banks are required to explain to borrowers that taking such products put them at a disadvantage.

Malaysia's Consumer Credit Oversight Board Task Force (CCOB) has released its second public consultation paper (CP2) earlier this month. Among the areas covered is a proposal to revise the Hire Purchase Act to make Rule of 78 illegal.

A press statement by CCOB said, “CP2 also covers proposed enhancements to the Hire Purchase Act 1967 (HPA 1967). These enhancements are aimed at modernising the act and improving consumer outcomes. In particular, CCOB Task Force is seeking feedback on the proposed removal of Rule 78. Such rule pre-calculates interest charges on hire purchase contracts as such that more interest is paid in the earlier period of the loan tenure. This financing method can lead to unfair outcomes for borrowers opting for early settlement.”

What is Rule of 78

Rule of 78 is a method of calculating interest rates for car loans (only applicable to fixed interest rate ones). It loads a disproportionate of the payable interest in the first half of the loan’s tenure.

Even if a borrower makes an early settlement, the savings are minimal.

“Rule of 78 is a financing method that allocates pre-calculated interest charges, with repayment instalments structured to frontload much higher interest payments in the earlier period of the loan tenure. The direct negative consequence to a hire purchase loan with a flat rate and Rule of 78 method is that borrowers who opt for early settlement of their hire purchase loan will have a higher principal loan balance to repay given their paid loan instalments would have comprised largely of the interest portion. This may be seen as unfair to the borrowers,” said the CP2 paper.

Why 9-year loans and Rule of 78 are bad

If you took out a 9-year loan but want to make a full settlement on the fifth year, you don’t save much because you’ve already paid the bulk of the interest. What you are doing now is merely paying back the principal amount (borrowed sum, excluding interest) owed.

If you took out a 9-year loan of RM 100,000 at 2.5 percent interest, you are paying RM 22,500 in interest alone. That’s more than 20 percent of the borrowed amount!

You will be paying RM 1,134 every month for the next 108 months. If your nett monthly salary is RM 5,000, about 20 percent of your salary goes the car - which is still within financial planning guidelines but here’s the fallacy, you haven’t factor in maintenance and insurance.

Nine years is a very long time to pay for a car. A lot of things can happen. Should your car meet with an unfortunate incident and you must sell your car, you may not be able to do so because your now junk of a car’s resale value / insurance's payment for total-loss is less than what you owe the bank. You cannot sell the car without putting in more money.

That’s a terrible situation to be in because you have to continue paying for a car that you can’t use, or is no longer working properly.

Irrespective of what car you own, resale values drop considerably once a vehicle’s age approaches 10 years, often dropping more than what you owe the bank. Accelerating the depreciation is banks’ aversion to finance cars that, at the end of the loan period, are older than 10 years. Yes, you can still get financing for used cars up to 13 years (age of vehicle at the end of loan period), but interest rates will be very high.

How much can I save if settle my car loan early?

The same borrower who took a 9-year loan of RM 100,000 at 2.5 percent fixed interest rate, paying RM 1,134 monthly, will save just RM 4,311 from the RM 22,500 total interest if he / she pays off the 9-year loan at its fifth year.

The reason for the pitiful savings? Rule of 78 allows the bank to collect a bulk of the total interest up front. Even if the borrower chooses to reduce his / her debt by making an early settlement, a big fat profit is guaranteed for the bank.

Rule of 78 binds the borrower to a very unfair risk-profit distribution relationship. The longer you stay in this contract, the better it is for the bank, the worse it is for you. Banks love car buyers taking 9-year loans to buy cars they can’t afford.

But taking a 9-year loan gives me more cash flow for investments

The cash flow argument is correct if you are taking a loan to finance the purchase of a more expensive but more efficient factory machinery that is going to make you more money, but it's different if you are stretching your budget to finance a depreciating value car you can't afford, one that isn’t going to make you any more money versus a cheaper Perodua Axia that still gets you to work and back in the same time.

Remember the pretend-rich BMW owners who borrowed from BMW Credit and at the peak of MCO, complained about not getting moratoriums? Hence the saying, "You only find out who is swimming naked when the tide goes out."

Also, unlike home loans, fixed interest rate car loans are calculated based on the borrowed sum. The monthly repayments stay the same even if the balance owed becomes lesser. Thus, the effective interest rate that you are paying for car loans is much, much higher.

This is unlike the reducing balance method used by home loans, where monthly repayments get lesser overtime as interests are calculated based on the balance owed.

What will replace Rule of 78?

The CP2 proposal paper reads: “To ensure fairness to borrowers, the Rule of 78 method will be replaced by a new formula using the reducing balance method and shall be used by hire purchase providers for both the calculation of term charges that are at a fixed rate or variable rate. The standardisation of the formula for fixed rate and variable rate term charges is also aimed at facilitating a better understanding to both credit consumers and hire purchase providers.”

When will Rule of 78 be abolished?

This is still at proposal stage. CCOB will be collecting public feedback email (CCAConsultation@bnm.gov.my) for CP2 until 15 May 2023.

Bank Negara Malaysia has yet to revise the Hire Purchase Act. Even if it does, it will only affect new hire purchase contracts. There will not be any impact to existing borrowers.

Also read: If you need a 9-year loan, you can’t afford the car, and do understand Rule of 78