There are three important things to know about add-on interest:
Interest is charged one time, in advance, and added to the loan balance. The amount of interest added to your balance is not based on a decreasing loan balance, like with a home mortgage. It’s based on the amount you originally borrowed, then multiplied by the number of years in the term of the loan. If you opt for a loan with add-on interest and decide to pay it off early, you won’t save any money.
Some lenders may use add-on interest because it allows them to collect more interest relative to an amortized loan, even if a borrower repays their loan early. In fact, choosing a loan with add-on interest means you’ll owe more interest than you would on most other types of loans. For each year you have an add-on interest loan, you’ll pay the same amount of interest as if you’d never paid down any of the principal balance.
How Add-On Interest Works
Suppose you need to borrow $20,000 to buy a new car. A dealership offers you financing that sounds decent: They’ll charge you $5 for every $100 you finance. You find the car you want and sign for a $20,000 add-on interest auto loan to be repaid on a monthly basis over five years at 5% interest.
Add-On Interest Example
Use the following steps to determine how much interest to add to calculate your new principal balance and your payment:
Calculate the annual interest: Multiply the interest rate by the amount you originally borrowed: 5% x $20,000 = $1,000Calculate the add-on interest amount: Multiply the annual interest amount by the number of years in the loan: $1,000 x 5 years = $5,000Determine the new principal balance amount: Add the add-on interest to the amount you borrowed: $5,000 + $20,000 = $25,000Determine your payment: Your payment equals new principal balance divided by the number of months in the loan: $25,000/60 = $417/month
Add-On Interest vs. Amortization
Amortization is commonly seen on auto loans and home loans. Like an add-on interest loan, the payment you make each month stays the same. But unlike an add-on interest loan, interest isn’t charged in advance; rather, it’s assessed based on the current amount of principal you owe. In other words, as you make payments toward and reduce the principal balance of your loan, the amount of interest you’re charged decreases. If you pay off your loan early, you will pay less interest than if you hold the loan for the duration of its term. For example, suppose you have a $20,000 auto loan at 5% interest to be repaid on a monthly basis over five years. This time, it’s not an add-on interest loan, but an amortized loan. Using an amortization calculator, you can see the monthly payment is $377. If you pay off the loan after the first year, you’d have made payments totalling $4,529 plus the remaining principal amount of $16,389, for a total of $20,918. However, if you hold that same loan for the full five years, you’d have paid a total of $22,645, which is $1,727 more. When compared to the amortized auto loan above, you can see that payments using add-on interest are substantially more expensive.
