How Add-On Interest Works

After a loan company calculates the loan's interest, they will apply add-on interest to either the amount you borrowed or the loan's principal. Add-on interest aims to ensure the repayment of all the interest even if the repayment of the loan is completed earlier than the life of the loan. Also, add-on interest is a method of calculation used when obtaining a loan or a mortgage. In this calculation method, the amount to be paid back is determined during the loan creation.

To determine the add-on interest of a loan the calculation combines total interest and total principal to the amount borrowed. The figure is then multiplied by the number of repayment years. The total interest is divided by the number of months to determine the monthly interest. Once the add-on interest is achieved, the loan's monthly payment and the add-on interest monthly payment are added to provide a total monthly payment of the loan.

Compared to the traditional method of calculating interest, also known as simple interest, add-on interest tends to be more expensive for the borrower. Due to this, add-on interest is rarely used when it comes to consumer loans.

Example of Add-On Interest

Kevin is a borrower, and he obtains a loan of $25,000. The add-on interest of the loan is 8%, the loan has to be paid over four years.

The principal amount for monthly payments will be $25,000/48 months = $520.83.

Every month the add-on interest amount will be ($25,000 * 0.08/12) = $166.67.

Every month the borrower must pay $166.67 + $520.83 = $687.50.

The total amount of add-on interest paid for the life of the loan will be $166.67*48 = $8,000.

Simple Interest vs. Add-On Interest

With simple interest, the interest to be paid depends on the owed principal after payment. Lenders can use add-on interests in circumstances like when a subprime borrower is involved or with short-term installments.

The payment made every month may be identical for loans that use simple interest because there is an increase in the principal paid with time, while on the other hand, there is a decrease in interest paid. If you are a borrower of a loan with simple interest you can make substantial savings if you pay the loan off early.

However, when it comes to add-on interest loans, first, there is the calculation of the amount owed, which will be the principal borrowed in total, adding the annual interest. Then that figure is multiplied by the number of years until full repayment of the loan. To obtain the amount paid monthly, the total owed amount is divided by the number of all the months for the payment. A loan with add-on interest makes the monthly interest owed constant, and paying off a loan early will not save a borrower any money.