Add-on interest refers to the calculation method of determining the total interest to be paid on a loan. Once the interest’s been added to the principal, the amount is divided by the number of months in the duration of the loan to determine the amount of the monthly loan payment.
Add-on interest refers to the calculation method of determining the total interest to be paid on a loan.
Add-on interest is usually compared with simple interest and is found to be much more expensive to the borrower because the monthly payments are fixed, and the installments are the same for each payment period.
Simple interest loans base the interest charged on the amount owed on the remaining principal after each monthly payment is made.
How is Add-On Interest Calculated?
The amount owed is calculated in the beginning as the total of the principal borrowed and annual interest multiplied by the number of years it takes for the loan to be fully repaid. The total is then divided by the number of months of payments to find the monthly payment.
There are two important formulas that are critical to ensuring one’s understanding of add-on interest:
First, calculate the total amount of interest that needs to be paid by multiplying the principal by the annual interest rate and the length of the loan.
Interest = Principal x Annual Interest Rate x Term
Next, the amount for each monthly payment needs to be determined by adding the principal and interest amounts (the latter calculated using the first formula) and dividing it by the total number of payments.
Assuming that payments are made monthly, the total number of payments will be the total number of months of the loan’s duration. The monthly payment amount can be calculated using the formula:
Payment = (Principal + Interest) / Total Number of Payments
Implications of Add-On Interest
Add-on interest is often compared to simple interest, which is one of the most common interest calculation methods used for loans.
The simple interest charged is calculated based on the amount owed on the remaining principal after each payment is made. While the entire payment made every month may remain the same over time, the principal paid increases as the interest paid decreases. If the interest is paid off earlier, there can be significant savings.
Add-on interest, on the other hand, does not offer the opportunity for savings since the monthly interest payments are pre-determined and are exactly the same throughout the loan duration.
The interest charged remains the same every month, even if the loan is paid off earlier. For each repayment, the borrower is only returning a portion of the principal and is still charged interest on that amount. This means the add-on interest method will cost a borrower more money than other methods.
The add-on interest is calculated as if no payments will be made until the loan has fully matured. As such, add-on interest is often perceived as being significantly more expensive than other types of interest calculation methods such as simple interest.
Add-On Interest Example
An individual obtains a $100,000 loan to be repaid over five years at an add-on interest rate of 6%. Remember that there are 60 months in five years. The principal that must be repaid each month will be $1,666.67 ($100,000/60 months).
Using a similar calculation, we can determine that the interest that needs to be repaid each month will be $500 (($100,000 x 6%)/12 months per year). Using the add-on interest calculation method, the individual will need to make a monthly payment of $2,166.67. The total amount of interest paid over five years of the loan will be $30,000 ($100,000 x 6% x 5 years).
When is Add-on Interest Used?
Add-on interest is used for short-term loans, auto loans, purchasing appliances, and mortgage payments. It may also be used for subprime borrowers.
Since add-on interest is much more expensive compared to simple interest, consumers tend to avoid it and shop around until they are able to find a similar loan that uses simple interest.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
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