Add-On Interest

Add-on interest is an alternative method of calculating interest whereby the interest payable is determined at the beginning of a loan and added onto the principal with each payment. In an add-on interest loan the interest is calculated annually and multiplied by the number of years to repayment. The amount of interest added to each payment remains constant throughout the entire loan. Add-on interest loans are much more costly to borrowers than other types of traditional loans.

Add-on interest is a type of loan methodology that can be used by financial institutions in lending. It can be compared with Rule of 78 loans and simple interest loans. Simple interest loans are a common type of loan methodology used by traditional lenders. Add-on interest and Rule of 78 loans are both alternative methodologies that financial institutions may use as well.

Add-on interest loans are more profitable for financial institutions because they require greater interest to be paid by the borrower. In an add-on interest loan the interest is calculated as a percent of the principal annually and multiplied by the number of years to repayment. Once the total amount of interest has been determined it can then be divided by the number of total payments and added to the principal paid each month.

For example, let's say a borrower gets a $25,000 loan at an 8% add-on interest rate that is expected to be repaid over four years. The total interest they owe would be $8,000 ($25,000 x 0.08 x 4). The amount of principal owed each month would be $520.83. The amount of interest owed each month would be $166.67. Therefore, the borrower would be required to make payments of $687.50 each month.

Add-on interest loans are much more costly for borrowers. If the borrower from the above example had obtained a $25,000 simple interest loan they would have saved substantially over the life of the loan. Using a simple interest loan payment calculator, a borrower with the same 8% interest rate on a $25,000 loan over four years would have calculated required monthly payments of $610.32 for total interest of $3,586.62.

In an add-on interest loan the lender would have increased their profit by $4,413.38. Add-on interest loans are not a common type of consumer loan. They may be used in short term installment loans and loans to subprime borrowers. Often subprime borrowers are willing to pay higher rates of interest in order to obtain a loan from an alternative lender.