The debate is now focused on whether it can bring about a more consumer-friendly landscape without negatively impacting the stability of the banking sector 

by VEISHNAWI NEHRU 

RULE 78 has long been a fundamental practice in personal financing. But is it fair to borrowers? 

This method, which front-loads interest payments, ensures that banks secure a larger portion of the interest early in the loan term. 

While this benefits lenders by providing more profit upfront, it also means that borrowers are stuck paying a disproportionate amount of interest in the beginning, even if they choose to pay off their loan early. 

As Bank Negara Malaysia (BNM) considers the abolition of Rule 78, it raises important questions about the fairness of such practices. Could this shift open the door for a more balanced approach to financing, where borrowers aren’t penalised for early repayment? 

In December 2024, BNM released an exposure draft on personal financing which introduces new requirements to abolish the offering of personal financing where interest/profit charges are computed using a flat rate with Rule of 78 method. Feedback for the exposure draft closes on Feb 14. 

The document noted that abolishment of the practice was consistent with the joint efforts by the central bank, the Consumer Credit Oversight Board (CCOB) Task Force and Ministry of Domestic Trade and Living Costs to prohibit the use of flat rate with Rule 78 method through amendments in the Hire Purchase Act 1967, which is scheduled for tabling in Parliament in the first half of 2025. 

The Rule 78 method refers to an interest/profit calculation method by multiplying the total interest/ profit payable over the loan/ financing tenure by a fraction, the numerator of which is the number of periods remaining on such financing at the time the calculation is made, and the denominator of which is the sum of all the whole numbers from one to the number which is the total number of complete months in the period of the loan/financing agreement. 

So, what is the rule all about? 

The exposure draft says the Rule 78 method is an interest/profit calculation method by multiplying the total interest/profit payable over the loan/financing tenure by a fraction, the numerator of which is the number of periods remaining on such financing at the time the calculation is made, and the denominator of which is the sum of all the whole numbers from one to the number which is the total number of complete months in the period of the loan/financing agreement. 

While banks may face challenges in adjusting to a new structure, the debate is now focused on whether the removal of Rule 78 can bring about a more consumer-friendly landscape without negatively impacting the stability of the banking sector. 

The Impact of Removing Rule 78

MBSB Bank Bhd, the country’s second-largest standalone Islamic bank after Bank Islam Malaysia Bhd, has done away with Rule 78. 

MBSB Holding group CEO Rafe Haneef said the financial institution no longer deploys Rule 78 for personal finance and the transition is already underway. 

“If the whole industry moves away from Rule 78, product prices could rise because banks would require a higher margin,” he told a recent panel discussion on the issue organised by the INCEIF University in Kuala Lumpur.

He noted that Rule 78 was popular as lenders in those days realised some borrowers ended up paying up earlier.

“Some people pay early. If you pay early, the lender benefits more,” he added. 

If Person A takes Rule 78, after three months, his payments would have totalled 33. Under the flat rate, it would have resulted in 19.5. When both parties prepay, Person A would receive a higher rebate compared to the other person. 

“Lenders realised that since some borrowers repay early and others repay until maturity, this creates a balance in profits and reduces overall rates,” he said. 

He explained switching to a fixed rate means everyone pays the same amount (6.5 per month), which eliminates the benefits of Rule 78. 

“The overall product pricing would increase as a result, as lenders would no longer benefit from varied repayment behaviour.” 

Moreover, Rafe stated a similar principle applies in retail as when a mix of cash and credit card payments is accepted, merchants can manage pricing. 

“But if everyone uses credit cards, prices increase due to the merchant discount rate.” 

Loan Structures, Borrower Understanding 

INCEIF University Assoc Dean Dr Zulkarnain Muhamad Sori explained that while some people suggest dividing profits equally, banks have their own business practices. 

“In some countries like the US, Rule 78 is limited to loans over five years. Other regions focus on transparency and fairness.” 

He said refinancing or overlapping loans is common in Malaysia, allowing banks to secure significant profits upfront. 

He explained that the new method, such as the effective interest method under MFRS 9 or IFRS 9, apportions profit differently. 

However, the profit collection pattern remains similar, with the difference being that in reducing balance methods, paying the principal early reduces interest. 

He explained that Rule 78, which dates back to the 1930s, uses a sum-of-digits method, meaning the bank collects more profit in the early months of the loan. So, in car financing, for example, the first payment mostly goes towards profit. For the final payment, only a small portion is profit. 

Benefits of Reducing Balance Structure 

Association of Islamic Banking and Financial Institutions Malaysia representative Amir Alfatakh Yusof said borrowers who enjoy a Rule 78 structure in the first year could still convert to a reduced balance structure for early settlement benefits. 

“For new personal financing, many banks now offer floating or fixed-rate products, no longer using Rule 78.” 

Amir added a reducing balance structure is beneficial, especially for early settlement, and noted that moving away from Rule 78 encourages this. 

“This is something the market now realises, as the reducing balance structure offers clear benefits for early settlement compared to Rule 78.” 

He said the calculation of Rule 78 is simple but doesn’t account for reducing principal over time. In contrast, the fixed-rate structure uses a reducing balance method, where profit is calculated based on the outstanding principal each month. 

“This can translate into bigger savings, especially for customers who want to reduce payments.” 

While the industry can absorb the shift, he said it could lead to higher overall financing costs. 

Amir also explained that when converting from a flat-rate Rule 78 structure, the principal remains high in the early years. The decision should be based on whether there are actual savings and if the customer understands the benefits of conversion. 

In a conversion scenario, he said if refinancing or conversion happens near the end of the tenure, the customer may still end up paying more due to the higher initial principal. 

“If there’s a requirement to convert from Rule 78 to a reducing balance structure, it may impact the customer adversely, causing them to pay more. 

“The decision is whether to allow those already under Rule 78 to continue until the end of their tenure, while new applicants could apply for the reducing balance structure,” he said. 

When discussing the fixed-rate structure, he said: “The calculation is based on reducing balance, which is calculated based on amortised quarterly calculation, just like how you calculate any other financing. The profit is based on the reduced scheduled principal balance. 

“The industry is more than capable. We already have fixed-rate products and services that can absorb the change. But it could lead to a higher overall cost of financing. 

“Legally, if you want to shift or convert from the existing fixed rate to a reducing balance, there could be some re-akad requirements to be done if the balances are big enough.”

• This article first appeared in The Malaysian Reserve weekly print edition