Definition and Examples of the Rule of 78
If you are considering paying off a loan early, it might be helpful to know how much interest you will save by paying the loan off before its due date. While it always seems like a good idea to pay off debt as quickly as possible, in some cases you may achieve a greater gain by investing your money instead of saving amounts in interest. The Rule of 78 can be used to help you determine how much money you will recover on any interest payments, financing charges, or credit insurance once you pay off your account in full.
The Rule of 78 organizes interest and payments in such a way that borrowers pay more interest at the beginning of the loan and pay less in interest as their debt is paid down. If you’re far along in the debt repayment process, the Rule of 78 may reveal that paying off the loan early won’t save you much money.
Some lenders use the Rule of 78, also known as the “sum of the digits,” to figure out how much interest the borrower has actually paid on the loan. Under the Truth in Lending Act, lenders must disclose to borrowers if they are entitled to a refund when they pay off their loan early. However, if you plan to make an early loan payment, don’t wait for the lender to mention any potential refund. It’s always worth inquiring about a refund on your own.
How the Rule of 78 Works
The Rule of 78 provides a method for calculating interest refunds for any pre-computed consumer credit transaction. It can be easier to calculate than other methods and is more favorable for lenders than for borrowers. Since September 30, 1993, loans must have a term of more than 61 months to qualify for the Rule of 78. Some states completely prohibit the use of the Rule of 78.
This formula shows how to calculate the refund using the Rule of 78:
(U x (U + 1)) / (T x (T + 1)) = Rule of 78 refund fraction x F = refund
U: unearned periods
T: term periods
F: financing charges
Let’s take a look at this formula in action, with a 12-month contract that the borrower has paid three months in advance (leaving nine unearned months). They have a financing charge of $100.
U = 9
T = 12
F = $100
(9 x (9 + 1)) / (12 (12 + 1)) = (9 x 10) / (12 x 13) = 90 / 156 = 0.5769
0.5769 x 100 (financing charge) = $57.69 refund
Alternatives to the Rule of 78
The Rule of 78 is not the only way to calculate interest (and unearned interest refunds if the loan is paid off early). There are other methods such as simple interest, insurance interest, and daily simple interest.
Key Takeaways
The Rule of 78 is used to calculate interest refunds for borrowers who pay off a credit product early. The Rule of 78 is also referred to as the “sum of the digits” because of the way it assigns values to the months of the year. The Truth in Lending Act requires lenders to disclose to borrowers if they are entitled to a refund after paying their loan off early.
Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Cornell Law School: Legal Information Institute. “15 U.S. Code § 1615 – Prohibition on use of the Rule of 78 in connection with refinancing mortgage loans and other consumer loans.” Accessed July 19, 2021.
Source: https://www.thebalancemoney.com/what-is-the-rule-of-78-5193164
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