The Rule of 78: Hidden Penalty for Prepayment in Consumer Credit Transactions
![handle is hein.journals/bulr55 and id is 339 raw text is: THE RULE OF 78: HIDDEN PENALTY FOR
PREPAYMENT IN CONSUMER
CREDIT TRANSACTIONS
JAMES H. HUNT*
I. INTRODUCTION
The extension of consumer credit in the United States, for both loans
and sales financing, is a multibillion dollar enterprise.' In precomputed
consumer credit transactions,2 the total debt is the sum of the amourit
financed and the finance charge for the entire term of the indebtedness.
Monthly payments are applied to the amount of the indebtedness without
allocation between interest and principal. Upon prepayment of the re-
maining monthly installments due on the indebtedness, it becomes neces-
sary to determine the unearned portion of the total finance charge; this is
the amount, less any prepayment charges, to which the debtor is entitled.3
The Rule of 78 is the popular name given to the method commonly used
to compute the amount of this rebate. Although the true amount of the
unearned finance charge can be found only through use of the actuarial
method,4 prevailing authority has considered the Rule to be a remark-
* B.A., Middlebury College, 1954. Fellow of the Society of Actuaries. Member of the
American Academy of Actuaries. The tables and examples in this article were prepared by
the author unless otherwise indicated.
See Mourning v. Family Publications Serv., Inc., 411 U.S. 356, 363 (1973).
2 A precomputed consumer credit transaction is one in which the debt is a sum
comprising the amount financed and the amount of the total finance charge for the term of
indebtedness, computed in advance. Monthly payments, without allocation of interest and
principal, are applied to the amount of the debt as they are received, The balance due on
the debt at any time, exclusive of any late charges or other special charges, is the sum of the
remaining. monthly payments. See CCH Installment Credit Guide, Uniform Consumer
Credit Code Final Draft 48 (1974) [hereinafter cited as UCCC]. See also Financial Publishing
Co., Cost of Personal Borrowing 19 (1974). A nonprecomputed credit transaction is one in
which the debt is the amount financed or borrowed exclusive of any interest or finance
charges, such charges being computed periodically on the debt outstanding. The amount of
the debt is called the principal, or outstanding balance. One example of a nonprecomputed
debt is a first real estate mortgage loan.
3 Technically, for a precomputed credit transaction, the debtor who wishes to prepay
must first tender to the creditor the sum of the remaining monthly payments; having done
so, he is eligible to receive a refund of the unearned finance charge. To illustrate, suppose
$1,000 is borrowed with a finance charge of $200, repayable in 24 monthly payments. The
precomputed indebtedness is $1,200 initially, and, prior to the first monthly payment of
$50-$1,200 divided by 24-the debtor must offer this amount in order to prepay the debt,
even though he borrowed only $1,000. Having done so, he then qualifies for a refund of the
unearned portion of the $200 finance charge. See, e.g., Pa. Stat. Ann. tit. 69, § 622 (1965). In
practice, the net amount is sufficient to prepay the debt. It is this feature-that the debt is the
sum of the monthly payments remaining, or unpaid time balance-that distinguishes a
precomputed consumer credit transaction from an outstanding balance transaction, in which
the amount necessary to prepay the debt is the principal outstanding plus interest to date of
prepayment.
4 The actuarial rate expresses the true return on an investment. Financial Publishing
Co., Financial Rate Translator 3 (1969). The Financial Publishing Company is a leading
publisher of financial tables for the consumer finance and banking industries. The com-
pany's expertise was recognized by the drafters of the UCCC when they relied on the
company for complex calculations. See UCCC 75.](ViewImageLocal?handle=hein.journals/bulr55&div=24&collection=&method=preview&ext=.png&size=3)
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The Rule of 78: Hidden Penalty for Prepayment in Consumer Credit Transactions
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