Add-On Interest Explained: Definition, Calculation, and Comparison with Simple Interest

Julia Kagan is a financial and consumer journalist, formerly a senior personal finance editor at Investopedia.

What Is Add-On Interest?

When searching for a loan, it's crucial to find the most cost-effective option. While the interest rate matters, the method used to calculate interest can significantly affect the total amount you pay. Add-on interest loans typically favor lenders, resulting in higher payments, even if you repay the loan early.

Add-on interest calculates the loan cost by adding the total interest over the loan’s life to the principal upfront, then dividing this sum by the number of payments. This means each monthly payment includes a fixed portion of interest regardless of how much principal remains.

This approach is generally more expensive for borrowers than simple interest loans, where interest is charged only on the outstanding principal after each payment. Add-on interest loans are uncommon in consumer lending but may be used for short-term installment loans or loans to subprime borrowers.

Key Points to Remember

• Simple interest loans charge interest based on the remaining principal balance after each payment.
• Add-on interest loans combine principal and total interest into equal monthly payments, increasing overall costs.
• Add-on interest is often applied in short-term loans and loans to borrowers with lower credit scores.

How Add-On Interest Works

In simple interest loans, monthly payments typically remain the same, but the portion allocated to principal increases while interest decreases over time. Paying off a simple interest loan early reduces the total interest paid.

Conversely, add-on interest loans calculate total interest upfront and spread it evenly across payments. The interest portion does not decrease, so early repayment does not reduce the interest cost.

Example of an Add-On Interest Loan

Imagine borrowing $25,000 at an 8% add-on interest rate over four years:

• Annual interest: $25,000 × 8% = $2,000
• Total interest over 4 years: $2,000 × 4 = $8,000
• Total amount owed: $25,000 + $8,000 = $33,000
• Monthly payment: $33,000 ÷ 48 months = approximately $687.50

By contrast, a simple interest loan at 8% for the same amount and term would have monthly payments around $610.32, with total interest of $4,295.51. The add-on interest loan costs $3,704.49 more, assuming no early repayment on the simple interest loan.

How Can You Identify Add-On Interest Loans?

Check your loan agreement carefully for the interest calculation method. If unclear, ask your lender directly to confirm whether add-on interest applies.

Can Early Repayment Save Money on Add-On Interest Loans?

No. Since add-on interest is calculated on the full principal plus total interest upfront, paying off the loan early does not reduce interest costs. Simple interest loans, however, allow interest savings with early repayment.

What Is an Amortized Loan?

An amortized loan calculates interest based on the remaining principal balance. While monthly payments stay consistent, the portion applied to interest decreases and the portion applied to principal increases over time. Amortization calculators can help visualize this payment breakdown.

Final Thoughts

If you have less-than-perfect credit and are considering a loan, scrutinize the terms to see if add-on interest is charged. Often, it’s better to seek loans with simple interest to avoid unnecessarily high costs.

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