Add-On Interest

Definition

Add-on Interest is a method of calculating loan interest where the total interest for the entire loan period is calculated upfront and then added to the principal. The borrower is then required to repay the sum of principal and add-on interest over the term of the loan. This means that the borrower is paying interest on interest, unlike simple interest loans.

Phonetic

æd – ɑːn – ɪntrəst

Key Takeaways

1. Definition: Add-On Interest is a method of calculating loan interest where the total interest for the entire loan term is calculated up front and added to the principal amount. The sum of these two amounts (principal + total interest) is then divided over the term of the loan to determine the monthly payment. This is different from simple interest, where the interest is computed on the current outstanding balance of the loan only. 2. Cost: Loans that use add-on interest are often more costly. This is because the borrower is paying interest on the entire initial principal amount over the life of the loan, rather than on the remaining unpaid principal. Therefore, even though a borrower might be reducing the loan’s principal with each payment, they continue to pay the original interest sum calculated based on the full initial loan amount. 3. Usage: Add-On Interest is commonly used in short-term installment loans such as auto loans and personal loans. Borrowers should be aware of this and understand how it impacts their overall loan costs, especially when comparing loan offers.

Importance

Add-On Interest is a critical concept in business and finance as it greatly influences the cost of loans and financing decisions. Unlike simple interest methods where interest is calculated based on the remaining principal, Add-On Interest is calculated at the beginning of the loan based on the original amount, which makes the total payable interest much higher. Understanding this concept allows businesses and individuals to make informed decisions when choosing between different financing options. It helps in understanding the true cost of borrowing and in estimating the amount of periodic repayments throughout the loan term, thus allowing efficient financial planning and budgeting.

Explanation

Add-On Interest is primarily used as a method of calculating the interest to be paid back on a loan, added at the inception of the loan. The purpose of Add-On Interest is to assure a pre-calculated and constant stream of interest revenue for the lender over the life of the loan. It allows lenders to add the total interest payment to the principal loan amount upfront, and borrowers then repay the combined amount in equated installments over the term of the loan. In the context of business financing, lenders use the Add-On method when they need to ensure a specific yield from a loan, regardless of early payment by the borrower. It’s commonly used in short-term lending and for borrowers who may wish to pay off their loan ahead of schedule, such as auto loans or installment loans. In this way, even if a borrower decides to repay their loan early, the lender still receives the amount of interest they expected.

Examples

1. Auto Loans: Auto dealerships often use add-on interest when they finance a vehicle purchase. After you select a vehicle and negotiate the price, the dealership determines the interest on the entire amount for the duration of the loan and adds it to the initial amount. This total amount is then divided by the number of payments (typically monthly) over the term of the loan. 2. Installment Loans: Installment loans are another common situation where add-on interest is used. For instance, if you buy furniture or a large appliance and finance it through the retailer, they may add the interest for your entire repayment period to your principal at the time the loan is made. 3. Personal Loans: Some personal loan lenders use add-on interest method, especially if it’s a lower sum and shorter time frame. For example, if you borrow $1,000 for a year at 10% add-on interest, interest of $100 (1000 x 10/100) would be added to the principal. The repayment sum would then be $1,100, divided equally amongst the 12 months.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Principal Amount
• Loan Term
• Interest Rate
• Amortization Schedule
• Unsecured Loan

Sources for More Information

• Investopedia
• Corporate Finance Institute
• The Balance
• Finder.com