Rule of 78s Explained | Rebate Calculation Logic
Outside of banking circles, the Rule-of-78′s is little understood, even though it is commonly applied to many consumer and business loans. For the borrower, it tends to have a pernicious effect in the nature of a hidden prepayment penalty. The borrower’s disadvantage is heightened by the fact that the operation of the Rule-of-78′s is often referred to as a “Rebate of the Finance Charge.” Any consumer who heard the word “rebate” is always tempted to say, “Where do I sign?”
Not so fast!
Here’s how it works: The name comes from the sum of the numbers one through 12, there being 12 months in a year. Yes, that adds to 78.
The theory of the Rule-of-78′s is that at the moment a borrower signs the Note, the borrower is immediately obligated to pay back all of the principal and ALL of the interest that will accrue in the future over the agreed term of the loan.
Now, if the borrower prepays, the lender “generously” forgives some of the interest EVEN THOUGH at the time for it to accrue has not yet elapsed and so that additional interest has not bee