nts

• What Is Add-On Interest?
• Understanding Add-On Interest
• Example of an Add-On Interest Loan
• FAQs
• The Bottom Line

Add-On Interest: Definition, Formula, Cost vs. Simple Interest

By 

Julia Kagan

Updated August 07, 2024

Reviewed by Julius Mansa

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Definition

If you’re looking for a loan, finding the most affordable option is important. While interest rate is a big factor, the way the interest is calculated can be just as important. Add-on interest loans tend to favor the lender, resulting in more money paid, even if the loan is paid off early.

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 over the life of the loan into a single figure. This combined amount is then divided by the number of monthly payments to be made. The result is a loan that combines the initial principal and total interest into one amount due, regardless of how much principal is repaid.

This method of calculating the payment on a loan is substantially more expensive for the borrower than the traditional simple interest calculation and is rarely used in consumer loans. Most loans use simple interest, where the interest charged is based on the amount of principal that is owed after each payment is made. Add-on interest loans may occasionally be used in short-term installment loans and in loans to subprime borrowers.

Key Takeaways

• Most loans are simple interest loans, where the interest is based on the amount owed on the remaining principal after each monthly payment is made.
• Add-on interest loans combine principal and interest into one amount owed, to be paid off in equal installments. The result is a substantially higher cost to the borrower.
• Add-on interest loans are typically used with short-term installment loans and for loans made to subprime borrowers.

Understanding Add-On Interest

In simple interest loans, where the interest charged is based on the amount of principal that’s owed after each payment is made, the payments may be identical in size from month to month, but that’s 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 upfront as a total of the principal borrowed plus the total interest owed over the life of the loan. This combined figured 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.

Example of an Add-On Interest Loan

Say a borrower obtains a $25,000 loan at an 8% add-on interest rate that’s to be repaid over four years.

• The total loan amount is multiplied by the interest rate to give us $2,000 interest per year ($25,000 * 0.08).
• The annual interest is multiplied by the term of four years to result in $8,000 total interest ($2,000 x 4 years).
• The initial principal and total interest are combined to reach the loan total of $33,000 ($25,000 + $8,000).
• To determine the monthly payment, the loan total is divided by the monthly term to reach roughly $687.50 ($33,000 / 48 months).

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 $4,295.51.

The borrower would pay $3,704.49 more for the add-on interest loan compared to the simple interest loan, assuming the borrower didn’t pay off the latter early, reducing the total interest even more.

How Do I Know That I’m Being Charged Add-On Interest?

Your loan agreement should disclose what interest calculating method is used. Read the fine print, and if you’re still unsure, ask your loan officer directly.

Can I Save Money on an Add-On Interest Loan by Paying It off Early?

Since all of the interest and principal is calculated at the onset of an add-on loan, paying off the total early won’t impact how much interest is paid on the loan. A simple interest or amortized loan offers the ability to save money on interest if you pay off the loan faster.

What Is an Amortized Loan?

An amortized loan is a loan that calculates the interest owed based on the existing principal. Although payments stay the same, as with an add-on interest loan, the amount of each payment that goes to principal vs. interest changes over time. Amortized loans tend to pay more of each payment to interest at the beginning of the loan, as the principal amount is higher. By the end of the loan, the balance shifts. An amortization calculator can help visualize your payments and how the ratio changes over time.

The Bottom Line

When researching a consumer loan, especially if you have poor credit, read the fine print carefully to determine whether the lender is charging you add-on interest. If that is the case, you’re likely better off continuing your search until you find a loan that charges simple interest.

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