What Is Add-On Interest?
Add-on interest is a method of calculating the interest to be paid on a loan by combining the total principal amount borrowed and the total interest due into a single figure, then multiplying that figure by the number of years to repayment. The total is then divided by the number of monthly payments to be made. The result is a loan that combines interest and principal into one amount due.
This is substantially more expensive for the borrower than the traditional simple interest calculation and is rarely used in consumer loans. Add-on interest loans may occasionally be used in short-term installment loans and in loans to subprime borrowers.
[Important: Most loans are so-called simple interest loans. That is, the interest charged is based on the amount of principal that is owed after each payment is made.]
Understanding Add-On Interest
Most loans are so-called simple interest loans. That is, the interest charged is based on the amount of principal that is owed after each payment is made. The payments may be identical in size from month to month, but that is because the principal paid increases over time while the interest paid decreases.
If the consumer pays off a simple interest loan early, the savings can be substantial. The number of interest payments that would have been attached to future monthly payments has been effectively erased.
But in an add-on interest loan, the amount owed is calculated up front as a total of the principal borrowed plus annual interest at the stated rate, multiplied by the number of years until the loan is fully repaid. That total owed is then divided by the number of months of payments due in order to arrive at a monthly payment figure.
This means that the interest owed each month remains constant throughout the life of the loan. The interest owed is much higher. And, even if the borrower pays off the loan early, the interest charged will be the same.
An Example of Add-On Interest
Say a borrower obtains a $25,000 loan at an 8% add-on interest rate that is to be repaid over four years.
The amount of principal to be paid each month would be $520.83.
The amount of interest owed each month would be $166.67.
Therefore, the borrower would be required to make payments of $687.50 each month.
The total interest paid would be $8,000 ($25,000 x 0.08 x 4).
Using a simple interest loan payment calculator, the same borrower with the same 8% interest rate on a $25,000 loan over four years would have required monthly payments of $610.32.
The total interest due would be $3,586.62.
The borrower would pay $4,413.38 more for the add-on interest loan compared to the simple interest loan. That is, if the borrower did not pay off the loan early, reducing the total interest even more.
- Most loans are simple interest loans. That is, the interest is based on the amount owed after each payment is made.
- The add-on interest loan combines principal and interest into one amount owed, to be paid off in equal installments.
- The result is a substantially higher cost to the consumer.