THE RULE OF 78

The "RULE OF 78" applies to precomputed interest loans.

• Forty-four States have enacted the Rule of 78. The mathematical or "sum-of-the-digits" formula for refunding unearned interest when an installment note is paid before maturity.
• The formula is based on the fact that more interest is earned in the early months of the debt, while the outstanding principal debt is larger, than in its later months when the creditor has recovered most of the money he loaned.
• Since the debtor is using 12 times as much of the creditor's money in the first month as in the final month, the creditor is mathematically earning 12 times as much interest in the first month as in the final month: 11 items as much in the second month; 10 times as much in the third month, etc.
• Accordingly, the Rule of 78 may be used to determine the correct mathematical allocation of each monthly installment between principal and interest.
• With the 12-month note, for example, the creditor merely adds the numbers 1 through 12, for a total of 78. As a unit, this sum represents the total interest charge for the life of the debt.
• Because the creditor is earning 12 times as much interest in the first month, 12/78 of the interest would be allocated to the first installment, 11/78 to the second installment, 10/78 to the third, etc.
• This means that the creditor earns 12/78 of the interest in the first month, plus 11/78 the second month, plus 10/78 in the third, etc.
• Thus, he has earned a total of 23/78 of the interest by the end of the second month, 33/78 by the end of the third month, etc.
• This determines the amount of interest to be refunded if the note is paid before maturity.
• For example, if the debtor repays during the second month, the creditor has earned 23/78 of the total interest, and 55/78 of the remainder is refundable to the debtor in the form of a credit to his note.
• If prepaid during the third month, the creditor has earned 33/78 of the total interest, thus 45/78 of the remainder is refundable, and so on throughout the life of the note.
• For a 24-month note, the numbers 1 through 24 would be added for a total of 300. Thus, the creditor would earn 24/300 of the interest in the first month, 23/300 the second month, etc.
• For a 36-month note, the numbers 1 through 36 would be added for a total of 666. The formula fits any monthly installment note, regardless of term.