Add-on Interest is a method of calculating interest on a loan where the interest amount is determined at the beginning of the loan and added to the principal amount. The borrower then repays the total of the principal plus the interest in equal installments over the life of the loan.
How Add-On Interest Works:
- Calculate Total Interest: The interest is calculated based on the entire principal amount, not on the decreasing balance. This means that the interest is fixed and does not decrease as you pay off the loan.
- Add Interest to Principal: Once the interest is calculated, it is added to the principal, creating a new, larger total amount that the borrower must repay.
- Repayment: The borrower makes equal payments over the loan term, with each payment consisting of both principal and interest. Since the interest is added upfront, each payment is the same throughout the loan period.
Example:
Suppose you borrow \$10,000 at an add-on interest rate of 10% for 3 years.
- Interest Calculation:
- Interest = \$10,000 * 10% * 3 years = \$3,000
- Total Amount Owed:
- Principal + Interest = \$10,000 + \$3,000 = \$13,000
- Monthly Payments:
- If the loan term is 3 years (36 months), your monthly payment would be \$13,000 / 36 = approximately \$361.11.
Key Characteristics:
- Higher Overall Cost: Add-on interest can be more expensive than other interest calculation methods, such as simple interest, because it doesn’t account for the decreasing balance.
- Fixed Payments: The payments remain consistent throughout the loan term, which can be easier for budgeting, but it also means you pay more interest compared to other methods.
- Less Common: This method is less common in traditional lending (like mortgages or auto loans) but might be seen in personal loans, certain types of installment loans, or in some high-cost loan products.
Considerations:
Before agreeing to a loan with add-on interest, it’s important to compare the overall cost with other types of loans, like those with simple interest, to ensure you’re getting the best deal.
