The rule of 78 formula is a little complicated compared to the annual percentage rate that is charged for most of the non-revolving loans. In both types of loans, the interest amount paid by the borrower remains the same it is just that the weight of the interest rate is higher in rule 78.
This rule is applied to the loans with a term period of one year or twelve months. If you add one to twelve months you would get the number 78, hence the name (1+2+3+4+5+6+7+8+9+10+11+12=78).
Once the sum of months is done, the lender will then weigh the interest rates in reverse order to make sure the maximum interest amount is collected from the borrower in the earlier loan cycle.
So the first month’s interest would be calculated as 12/78 of the total interest, for the second month it would be 11/78, the third month 10/78, and so on till the twelfth month where it would be 1/78.
Even if the borrower decides to pre-pay the loan, the lender will still cover most of the interest amount that is charged over the tenure of the loan.
The borrower ends up paying more interest up front in the early payment cycle compared to what he/she would pay otherwise in a simple interest calculation. If you are taking the loan for two years the rule changes from 78 to 300.
As per the Truth In Lending Act, the lender is supposed to disclose if the borrower is entitled to receive any refund in case of an early payoff of the loan. To calculate the refund, there is a specific formula that the lenders use.
(U x (U + 1)) / (T x (T + 1)) = Rule of 78 refund fraction x F = Refund. Where U is remaining term periods, T is term periods, and F is finance charge
For example, if the borrower has taken a 12 month loan there under this rule 78 and has make payment for two months.
This leaves with 10 months of payments and the borrower pre-pays the loan and the lender finance charge is $150. In this case the refund will be calculated in following way. U=10, T=12, F=$150
(10 x (10+1)) / (12 x (12+1)) = (10 x 11) / (12 x 13) = 110 / 156 = 0.705
0.705 x 150 (Finance Charge) = 105.75
In this example, if the borrower pays off the loan after making two payments he will receive a refund of $105.75 from the lender.