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 merges interest and principal into one consolidated amount due.
This method of loan payment calculation results in a much higher cost for the borrower than the traditional simple interest calculation and is infrequently used in consumer loans. Most loans utilize the simple interest method, where the interest is charged based on the remaining principal owing after each repayment period. However, add-on interest loans can sometimes be found in short-term installment loans and loans to subprime borrowers.
Key Takeaways
*Most loans employ simple interest where the interest is calculated based on the remaining principal after each installment.
- Add-on interest loans consolidate principal and interest into a single amount owed, repaid in equal installments.
- Borrowing costs significantly escalate with add-on interest loans.
- These loans are often associated with short-term installment loans and subprime borrower approvals.
Understanding Add-On Interest
In simple interest loans, the interest is calculated based on the remaining principal owed after each payment. While the monthly payments may remain consistent, the amount of principal versus interest in each payment shifts over time, with paying down the principal eventually absorbing more of the payment.
One might realize substantial savings by repaying a simple interest loan early, effectively reducing the future interest payments. However, add-on interest loans function differently: the total owed is determined upfront by summing the principal borrowed plus annual interest at the stated rate, multiplied by the loan’s payment term in years. This total is then divided by the number of months to determine the monthly payment amount.
This methodology fixes the monthly interest owed, making it consistently higher than in a standard simple interest loan. Even if the loan is repaid early, the interest burden remains unchanged.
Enhanced Example of Add-On Interest
Consider a borrower who secures a $25,000 loan at an 8% add-on interest rate, to be repaid over four years:
- The monthly principal repayment would be $520.83 ($25,000 / 48 months).
- The monthly interest component would be $166.67 ($25,000 x 0.08 / 12).
- The total monthly payment for the borrower would then be $687.50 ($520.83 + $166.67).
- Over the four-year period, the total interest paid sums up to $8,000 ($25,000 x 0.08 x 4).
For comparison, a simple interest loan with the same principal and interest rate over four years would result in monthly payments of $610.32 and a total interest cost of $3,586.62.
This considerable difference means the add-on interest loan would cost the borrower an extra $4,413.38, assuming the borrower didn’t refinance or repay the loan early to reduce total interest expenses further.
When considering a loan, especially if your credit score could be improved, always scrutinize the loan details for any signs of add-on interest. Aim to find loans using simple interest calculations for potentially substantial financial savings.
Related Terms: Principal, Interest, Simple Interest, Loan Repayment, Installment Loan, Subprime Borrowers.
