Add-On Interest

DEFINITION of 'Add-On Interest'

A method of calculating interest whereby the interest payable is determined at the beginning of a loan and added onto the principal. The sum of the interest and principal is the amount repayable upon maturity.

BREAKING DOWN 'Add-On Interest'

For example, let's say Bank A borrows $1,000 for two years from Bank B and that annual interest rates are 9%. Furthermore, Bank A will repay the loan in two equal repayments at the end of each year. The interest charge on the loan is $180 ($1,000 x 9% x 2 years). Adding this to the principal gives a total of $1,180. The annual payment will be $590 ($1,180/2).

When multiple repayments are used in add-on interest, the effective lending rate becomes higher than the nominal rate. This is caused the borrower returns a portion of the principal with each payment, but is still being charged interest on the amount of the original loan. In short, if you are borrowing under the add-on interest method, you are paying more.

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