Definition§
Add-On Interest is a method of calculating interest where the total interest amount for the duration of the loan is computed at the beginning of the loan term, based on the original principal balance. This total interest amount is then added to the loan principal, and the sum is divided into equal payments over the loan term. This calculation method typically results in a higher effective interest rate compared to other methods, such as the Annual Percentage Rate (APR), because the interest is calculated on the full original principal without accounting for periodic principal repayments.
Examples§
Example 1: Personal Loan§
Abel borrows $1,000 at 8% add-on interest for 4 years. The total interest due over the life of the loan is calculated as:
Therefore, Abel will repay a total of $1,320. Dividing this amount by the number of months (48 months in 4 years), Abel’s monthly payment will be:
\[ \frac{1,320}{48} \approx $27.50 \]
Example 2: Car Loan§
Consider a car loan of $10,000 with 6% add-on interest over 5 years. The interest would be calculated as follows:
Here, the total amount to be repaid is:
\[ 10,000 + 3,000 = $13,000 \]
Dividing this over the course of 60 months (5 years), the monthly payment would be:
\[ \frac{13,000}{60} \approx $216.67 \]
Frequently Asked Questions (FAQs)§
What is the main drawback of add-on interest loans?§
The main drawback of add-on interest loans is that they usually end up being more expensive for the borrower because interest is calculated on the total initial loan amount without accounting for periodic principal repayments.
How does add-on interest compare to APR?§
While add-on interest calculates total interest based on the initial loan amount, APR provides an effective annual rate that reflects the cost of borrowing, including interest and fees, accounting for the reducing principal balance over time. APR is generally a more accurate measure of the true cost of a loan.
Can add-on interest be used for both short-term and long-term loans?§
Yes, add-on interest can be used for both short-term and long-term loans, but it is more commonly applied in consumer finance, such as for personal loans and car loans.
What types of loans commonly use add-on interest?§
Add-on interest is commonly used in consumer finance products such as personal loans, car loans, and some small business loans. It is less common in mortgage financing and credit cards.
Is add-on interest advantageous for banks?§
Yes, add-on interest can be advantageous for lenders because it allows them to collect more interest over the life of the loan compared to loans where interest is calculated on a declining principal.
Related Terms§
Annual Percentage Rate (APR)§
Annual Percentage Rate (APR): APR is the annual rate charged for borrowing or earned through an investment, accounting for interest rate as well as fees or any other costs.
Principal§
Principal: The original sum of money borrowed or invested, before interest.
Compound Interest§
Compound Interest: Interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods.
Fixed Interest Rate§
Fixed Interest Rate: An interest rate that doesn’t change over the life of the loan or investment.
Online Resources§
- Investopedia: Add-On Interest Definition
- Consumer Financial Protection Bureau
- Federal Reserve Board: Interest on Loans
References§
- “Mortgage and Real Estate Finance: APR vs. Add-on Interest Rate”, Federal Reserve Bank.
- “Understanding Different Types of Loan Interest Rates”, CFPB.
Suggested Books for Further Studies§
- “Finance for Non-Financial Managers” by Gene Siciliano
- “Fundamentals of Financial Management” by Eugene Brigham and Joel Houston
- “Consumer Credit and the American Economy” by Thomas Durkin, Gregory Elliehausen, Michael Staten, and Todd Zywicki
