This is an accurate interest model only based on the assumption that the borrower pays only the amount due each month.
As such, the borrower pays a larger part of the total interest earlier in the term.
But because of some mathematical quirks, they end up paying a greater share of the interest upfront.
The denominator of a Rule of 78s loan is the sum of the integers between 1 and n, inclusive, where n is the number of payments.
Following the same pattern, 24/300 of the finance charge is assessed as the first month's portion of a 24-month pre-computed loan.
If a borrower plans on repaying the loan early, the formula below can be used to calculate the unearned interest.
Figure 1 is an amortized table for gradual repayment of a loan with $500 in interest fees.
If a borrower repaid their principal early, they were still required to pay the total interest agreed to in the contract.
In 1935, Indiana legislators passed laws governing the interest paid on prepaid loans.
The formula contained in this law, which determined the amount due to lenders, was called the "rule of 78" method.
The reasoning behind this rule was as follows: A loan of $3000 can be broken into three $1000 payments, and a total interest of $60 into six.
[4] This method above would be called 'rule of 6' (achieved by adding the integers 1-3), but because most loans around 1935 were for a 12 month period, the Rule of 78s was used.
In the United States, the use of the Rule of 78s is prohibited in connection with mortgage refinance and other consumer loans having a term exceeding 61 months.
The bill was referred to the House Committee on Financial Services on the same day.
[7] On April 10, 2001, the bill was referred to the Subcommittee on Financial Institutions and Consumer Credit, where it died with no further action taken.
Once the finance charge has been identified, the Rule of 78s is used to calculate the amount of the finance charge to be rebated (forgiven) in the event that the loan is repaid early, prior to the agreed upon number of payments.
If $10,000 is lent and the precomputed finance charge is $3,000, the borrower owes the lender $13,000 at the time the loan is made, whereas a simple interest borrower owes the lender only the $10,000 principal and monthly interest on the unpaid principal.
A simple explanation would be as follows: suppose that the total finance charge for a 12-month loan was $78.00.
If a person repaid a consumer loan after 3 months, the financial institution would not charge interest the sum of the "remaining" digits... i.e., 9,8,7,6,5,4,3,2,1 = $45.00, and would only retain the first three numbers... 12,11,10 or $33.00.