Some financiers use tables based on a mathematical formula called “The Rule of 78’s”-or sometimes “The Sum of the Digits”-to determine how much interest you have paid at any one point in a loan.
Under the Rule of 78 method, interest is calculated for the life of the loan and then allocated to each month by proportion using reverse sum of the digits methodology. You start by adding up the numbers of months for the note. For example, in a 12 month loan, counting month 1, plus month 2, and so forth through month 12 is:
1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12
This totals 78, and hence the name, rule of 78.
The simple interest total for the loan life (as given by the formula: Interest = Rate x Time x Principal) is divided by the sum of the digits (78 in this example) and applied in reverse proportion across the life of the loan. Thus, 12/78 of the interest applies to the first month, 11/78 to the second month, and so forth down to 1/78th at the end of the 12th month.
This formula takes into consideration the fact that you pay more interest in the beginning of a loan when you have the use of more of the money, and you pay less and less interest as the debt is reduced. Because each payment is the same size, the part going to pay back the amount borrowed increases as the part representing interest decreases.
This is an accurate interest model only based on the assumption that the borrower pays only the amount due each month. If the borrower pays off the loan early, this method maximizes the amount paid by applying funds to interest before principal.
Making payments before they are due does not reduce the total interest owed. Only when you pay off the entire loan early will you save interest. If you have extra money some months, put it in a savings account to accumulate until you can pay off the whole loan.
The final payoff figure on your loan depends primarily on the original time to maturity, but it may be affected by other factors, such as variances in the payment schedule or a lag between the date of calculation and the date of payment.
Keep in mind that paying off a loan in, say, 15 months instead of 30 as originally planned will not produce a saving of one-half of the interest.
What you receive as a rebate of charges is the amount which the finance company itself would earn for the remainder of the contract if you did not prepay the agreement.
For example, with a 3 year loan paid monthly, there are 36 monthly payments. Therefore, the amount of interest applied in month 7 is equal to 30 (remaining months including current) divided by 666 (sum of the sequence of terms between 0 and 36), multiplied by the total interest to be paid over the term of the loan.
You are entitled to rebates for complete months still to run. For example, if the agreement is for 12 months and three (3) installments have been paid and it is terminated between the third (3) and fourth (4) installment, then the number of complete months qualifying for the rebate is eight (8).