The add-on interest is a type of interest that is figured into the total cost of a loan over its entire life. The interest is added to the principal and divided by the number of monthly payments to determine the monthly payment amount. In other words, to define the add-on interest, you have to take the principal, then the annual interest is multiplied by the number of years of repayment and then divided by the number of months of repayment. The principal is also divided by the number of monthly payments and added to the monthly interest to get the final amount of monthly payments.
Something that the add-on interest can be compared to is the simple interest loan. With a simple interest loan, the interest is calculated every month based on the principal amount that still needs to be paid. By that interest method, the monthly interest decreases, and the monthly principal payment increases from the total amount to balance the payments out. This simple comparison shows that an add-on interest generates a higher cost from the borrower than the simple interest loan. The only interest that generates an even higher cost for the borrower is the compound interest loan.
With an add-on interest, the amount of interest owed for the principal is calculated at the beginning of the loan. Because of this, it doesn’t take into account the amounts of payments that go into the principal and recalculate the interest based on the actual value still owed. When the loan is approved, the interest is calculated for the whole period of the loan. Like this, the interest owed for the principal is much higher through the add-on interest method.
It’s always important to check the fine print when signing a loan contract. This is just one of the reasons why. Typically this type of interest is used for short-term loans that don’t extend for more than a few years. Still, there is always the single interest option that is much more affordable for the borrower.
John needs to borrow a $20,000 loan with an annual add-on interest rate of 8% to be repaid in four years. Based on the loan, we can determine that the amount of principal to be paid monthly will be $416.66. As the annual interest is multiplied by the number of years, we get a total interest of $6,400 ($20,000 x 0.08 x 4). Now, we take the total interest and divide it by the number of monthly payments and get $133.33 ($6,400/48) monthly interest payment.
We take the monthly interest payment and add the monthly principal payment and get a $550 (rounded up from $549.999) total monthly payment.