Legal Definitions - rule of 78

The Rule of 78 is a specific method once commonly used by lenders to calculate the amount of interest a borrower saves when paying off a loan earlier than scheduled. This rule is based on the assumption that a greater proportion of the total interest is paid during the initial months of a loan, even if the monthly principal and interest payments appear equal. It derives its name from the sum of the digits for a 12-month loan (1+2+3+...+12 = 78). When applied, it effectively front-loads interest, meaning borrowers save less interest on early payoffs than they might expect from a simple pro-rata calculation.

• Example 1: Early Car Loan Payoff

  Imagine a borrower takes out a 36-month loan for a new car. After 18 months, they receive a significant bonus at work and decide to pay off the remaining balance of the loan in full. If the loan agreement included the Rule of 78, the lender would use this method to calculate the interest rebate. This means the borrower would save less interest than if the interest were spread evenly across all payments, because the Rule of 78 assumes a larger share of the total interest was already paid during the first 18 months of the loan.

• Example 2: Small Business Equipment Financing

  A small business owner secures a 24-month loan to purchase new office equipment. Six months into the loan, the business experiences unexpected growth and decides to pay off the entire equipment loan to free up cash flow. If the loan contract specified the Rule of 78, the interest savings on this early payoff would be calculated using this method. The business would find that a substantial portion of the total interest was considered "earned" by the lender in those initial six months, reducing the amount of interest saved compared to a simple straight-line calculation.

• Example 3: Consumer Furniture Installment Plan

  A consumer purchases furniture on an 18-month installment plan offered by a retail store, where the financing agreement includes the Rule of 78. After nine months, the consumer decides to pay off the remaining balance. When calculating the final payoff amount, the store's finance department would apply the Rule of 78 to determine the outstanding interest. This would result in a smaller interest rebate for the consumer than if the interest had been allocated uniformly over the loan term, as the rule front-loads the interest payments to the earlier months.