Mathematical formula used in computing the interest rebated when a borrower pays off a loan before maturity. The Rule of 78's, also known as the Sum of the Digits, is applied mostly to consumer loans in which the finance charges were computed using the Add-on Interest or Discounted Interest method of interest calculation.
The formula for calculating rebates works as follows: add up the number of months for which payments are scheduled; in a 12-month installment loan, the total is 78. This number, divided by the number of payments to be made, equals the finance charge for that month. In the first month, the borrower has use of the whole amount borrowed, and the finance charge is 12⁄78 of the total interest; in the second month, it is 11⁄78, and so on. A $3,000 loan, paid in 15 equal installments of $225, has an interest payment of $28.13 in the first month, $26.25 in the second, and only $1.87 in the final month. Thus, under the add-on method, the finance charges in the early months are higher than later on, which means that paying off an installment loan early doesn't necessarily reduce the amount of interest the borrower would have paid. The Truth in Lending Act however, requires that lenders disclose how the finance charge will be computed if the debt is paid in full before maturity, so borrowers can weigh different financing alternatives before signing a loan agreement. See also Simple Interest.
