Add-On Interest: Definition, Examples, and Implications

Last updated 03/19/2024 by

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Summary:

Add-on interest, a less common method for calculating loan payments, combines both principal and interest into one amount, resulting in a more expensive loan for borrowers. In this article, we’ll delve deeper into add-on interest, its implications, and when it’s used.

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What is add-on interest?

Add-on interest is a method of determining the interest to be paid on a loan. It combines the total principal amount borrowed and the total interest due into a single figure. This combined amount is then multiplied by the number of years it takes to repay the loan. The final step involves dividing this sum by the total number of monthly payments, giving you the monthly payment amount.

How add-on interest works

In simple interest loans, payments may be identical in size each month because the principal paid increases over time while the interest paid decreases. This means that if a borrower pays off a simple interest loan early, they can save a substantial amount. The future monthly payments’ interest component gets effectively reduced.

However, add-on interest loans operate differently. The total amount owed is calculated upfront as the sum of the principal borrowed and the annual interest, multiplied by the number of years until the loan is fully repaid. This total is then divided by the number of months for payments, giving you a constant monthly payment figure.

This implies that the interest owed each month remains constant throughout the loan’s life. Consequently, the interest paid is considerably higher, and even if the borrower decides to pay off the loan early, the interest charged remains the same.

Pros and cons of add-on interest

Understanding add-on interest: an example

Let’s take a practical example to illustrate the impact of add-on interest. Suppose 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 ($25,000 / 48 months).

The amount of interest owed each month would be $166.67 ($25,000 x 0.08 / 12).

The borrower would be required to make payments of $687.50 each month ($520.83 + $166.67).

The total interest paid would be $8,000 ($25,000 x 0.08 x 4).

If the same borrower had taken a simple interest loan with the same 8% interest rate on a $25,000 loan over four years, they would have required monthly payments of $610.32. The total interest due would be $3,586.62.

So, for the add-on interest loan, the borrower would pay $4,413.38 more compared to the simple interest loan, assuming they didn’t pay off the loan early.

When add-on interest is used

Add-on interest loans are typically used with short-term installment loans and for loans made to subprime borrowers. These loans can be an option when a borrower has a limited credit history or poor credit and may not qualify for traditional, lower-cost loans.

Comparing add-on interest to simple interest

When it comes to understanding the cost differences between add-on interest and simple interest, let’s explore a more detailed example.

Example 1: Add-on interest loan

Suppose you take out a $15,000 loan with a 10% add-on interest rate to be repaid over five years. The calculation would be as follows:

– Principal per month: $15,000 / 60 months = $250
– Monthly interest: ($15,000 * 0.10) / 12 months = $125
– Total monthly payment: $250 (principal) + $125 (interest) = $375

Now, let’s see how this compares to a simple interest loan:

Example 2: Simple interest loan

Using the same $15,000 loan amount with a 10% interest rate, but this time with a simple interest calculation:

– Monthly interest would be ($15,000 * 0.10) / 12 months = $125
– Principal per month: ($15,000 / 60 months) = $250
– Total monthly payment: $250 (principal) + $125 (interest) = $375

In this example, both the add-on interest and simple interest loans result in the same monthly payment of $375. However, it’s essential to understand that the composition of these payments differs.

Real-world applications of add-on interest

Let’s explore how add-on interest is used in real-world situations.

Short-term installment loans

Add-on interest loans are often used in short-term installment loans. These loans are typically repaid over a shorter period, and the constant monthly payments can make budgeting easier for borrowers. However, the overall cost of such loans tends to be higher compared to simple interest loans.

Subprime lending

Add-on interest loans are also more prevalent in subprime lending. Subprime borrowers, who may have lower credit scores or limited credit histories, might find it challenging to qualify for traditional loans with lower interest rates. Add-on interest loans can be an option for lenders to mitigate the higher risk associated with these borrowers.

Conclusion

Add-on interest is a less common method of calculating interest on loans that combines both principal and interest into one monthly payment. While it can make budgeting simpler, it often results in a higher overall cost for borrowers. These loans are typically used in short-term installment loans and for subprime borrowers.

When considering an add-on interest loan, it’s essential to read the fine print, understand the terms, and compare the total cost to other loan options. For many borrowers, simple interest loans are more cost-effective and flexible.

Frequently asked questions

Is add-on interest commonly used in consumer loans?

Not typically. Most consumer loans use the simple interest method, which bases interest charges on the remaining principal after each payment. Add-on interest is more commonly used in short-term installment loans and subprime lending.

Why do some borrowers choose add-on interest loans?

Add-on interest loans can simplify budgeting for borrowers because the monthly payments remain constant throughout the loan’s term. They may be chosen by borrowers who prefer predictability in their payments or have limited credit options.

How can I calculate the total cost of an add-on interest loan?

To calculate the total cost of an add-on interest loan, you can multiply the total number of monthly payments by the constant monthly payment amount. Subtract the original principal amount to find the total interest paid. Keep in mind that the interest component remains constant throughout the loan’s term.

Are there any advantages to add-on interest loans?

One advantage of add-on interest loans is their simplicity. They are easy to understand, and borrowers can predict their monthly payments accurately. This can make budgeting more straightforward, particularly for those who have a fixed income.

What should I consider before choosing an add-on interest loan?

Before selecting an add-on interest loan, carefully read the terms and conditions. Consider the total cost over the loan term and compare it to other financing options. If you anticipate paying off the loan early, a simple interest loan might be a more cost-effective choice.

Key takeaways

Add-on interest combines both principal and interest into a single monthly payment, simplifying budgeting for borrowers.
Monthly payments with add-on interest remain constant throughout the loan’s term.
Add-on interest loans are typically more expensive than simple interest loans, making them less cost-effective for borrowers, especially if they intend to pay off the loan early.
Comparing add-on interest to simple interest is essential to understand the differences in cost composition, even if the monthly payments appear the same.
Real-world applications of add-on interest include short-term installment loans and subprime lending, where borrowers may not qualify for traditional, lower-cost loans.

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