Legal Definitions - rule of the sum of the digits

The Rule of the Sum of the Digits, commonly known as the Rule of 78, is a method used by lenders to calculate the amount of interest due on a loan, particularly when a borrower pays off the loan earlier than scheduled. This method allocates a larger proportion of the total interest to the earlier payments of the loan term, making early repayment less financially advantageous for the borrower compared to a simple interest calculation.

The name "Rule of 78" comes from the sum of the digits for a 12-month loan (1+2+3+...+12 = 78). For a loan of any length, the sum of the digits for the number of payment periods is calculated. This sum then serves as the denominator in a fraction, with the numerator being the number of remaining periods (in reverse order) to determine the interest allocated to each period. This front-loads the interest, meaning a borrower who pays off a loan early under this rule will have paid a disproportionately high amount of interest in the initial months.

• Example 1: Car Loan Early Payoff

  Imagine David takes out a 36-month car loan. After 12 months, he receives a large bonus and decides to pay off the entire remaining balance of his loan. If his loan agreement uses the Rule of 78, a substantial portion of the total interest for the entire 36-month period would have already been allocated to those first 12 months. Consequently, the actual interest savings he realizes by paying off the loan 24 months early might be less than he anticipated, because the interest was heavily front-loaded during the initial third of the loan term.

• Example 2: Furniture Store Financing

  A customer finances a new living room set through a furniture store with an 18-month payment plan. The financing agreement specifies that if the loan is paid off early, any interest rebate will be calculated using the Rule of 78. The customer manages to pay off the entire balance after only 6 months. Under the Rule of 78, the interest charged for those first six months would be disproportionately high compared to a simple interest calculation. This means that even though they paid off the debt quickly, a larger share of the total interest for the 18-month term would have already been applied to their balance, significantly reducing the benefit of their early repayment.

• Example 3: Short-Term Business Equipment Loan

  A small business owner secures a 6-month loan to purchase new office equipment. The loan agreement states that interest rebates for early repayment will be calculated using the Rule of 78. The business experiences unexpected growth and is able to repay the entire loan after just 2 months. Despite paying off the loan four months ahead of schedule, the business owner finds that the amount of interest rebated (returned) is not as substantial as they might have expected. This is because the Rule of 78 allocated a significant portion of the total interest for the 6-month term to the first two months, leaving a smaller amount of interest to be rebated for the unexpired portion of the loan.