Add-on interest is a way to calculate interest that differs from the way it’s calculated on other loans, such as amortized home loans. In an add-on interest loan, all the interest due is calculated at the start of the loan and added to the principal balance. Importantly, the amount of interest you owe does not change no matter how much of the principal you pay down.
Here’s a closer look at what add-on interest is and how it works.
Definition of Add-On Interest
A lender that uses add-on interest adds a certain amount of interest to the principal balance of your loan at the start of your loan. Instead of interest being charged on an ongoing basis to the remaining principal balance (as you reduce it by making payments), interest is calculated in advance. The interest calculated is based on an interest rate or specific dollar amount per $100 borrowed, and multiplied by the number of years in the term of the loan. This amount is added to the original principal balance to create a new principal balance.
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.
Add-on interest is more common with short-term loans as well as loans for subprime borrowers.
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 = $1,000
- Calculate the add-on interest amount: Multiply the annual interest amount by the number of years in the loan: $1,000 x 5 years = $5,000
- Determine the new principal balance amount: Add the add-on interest to the amount you borrowed: $5,000 + $20,000 = $25,000
- Determine your payment: Your payment equals new principal balance divided by the number of months in the loan: $25,000/60 = $417/month
The add-on interest method isn't the only way to calculate the amount of interest you owe. Other types of loans, such as amortized loans, might advertise a similar interest rate, but have a much lower annual percentage rate (APR).
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.
If you want to save money on interest, look for loans that are amortized or follow a simple interest method, rather than the add-on interest method.
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.
|5-Year Add-On Interest Loan||5-Year Amortized Loan|
|Total interest||$5,000||$2,645 (if held to term)|
|Total paid||$25,000||$22,645 (if held to term)|
With the add-on interest method, you would pay $25,000 to borrow $20,000 at the same rate and for the same term as the amortized loan. However, you’d pay at least $2,355 more with the add-on interest loan. This is because the monthly interest payments are predetermined and are computed on the original principal balance each year for every year you owe money on the loan. They don’t account for any reduction in the principal balance. And because interest is determined in advance, there’s no benefit to paying the loan off early.
- Loans with add-on interest combine the principal and interest into one total amount owed and must be repaid in equal payments.
- Add-on interest makes borrowing more expensive than other options.
- While they’re less common, add-on interest loans are seen in short-term loans and loans available to subprime borrowers.