What is add-on interest?
– Add-on interest is a loan pricing method that fixes the total interest charge at the start of the loan. The lender computes interest on the original principal for the full loan term, adds that interest to the principal, and then divides the combined amount into equal periodic payments. Because interest is calculated on the full original balance for the whole term, the borrower usually pays more interest than with standard simple-interest (amortized) loans.
Key definitions
– Principal: the amount borrowed.
– Interest rate (annual): the stated yearly rate (for add-on use the nominal rate).
– Simple interest: interest computed each period on the remaining loan balance; interest declines as principal is repaid.
– Amortized loan: a loan whose payments are structured so each periodic payment is the same, but the portion applied to interest versus principal changes over time (interest is based on outstanding principal).
– APR (annual percentage rate): a standardized disclosure of a loan’s cost that may include certain fees; useful for comparing offers.
How add-on interest is calculated (step-by-step)
1. Compute total interest: principal × annual rate × years.
2. Add that interest to the principal to get the total amount to be repaid.
3. Divide the total repayment by the number of payments to get the periodic payment.
Worked numeric example
Assumptions:
– Principal = $25,000
– Annual add-on rate = 8% (0.08)
– Term = 4 years = 48 months
Step 1 — total interest:
25,000 × 0.08 × 4 = $8,000
Step 2 — total repayment:
25,000 + 8,000 = $33,000
Step 3 — monthly payment:
33,000 ÷ 48 = $687.50 per month
Compare to an amortized (simple-interest) loan with the same 8% APR:
– Using standard amortization math, the monthly payment would be about $610.32 and total interest paid about $4,295.51 over 48 months. In this example, the add-on loan charges roughly $3,700 more in interest across the term.
Key contrasts (why add-on favors lenders)
– Add-on interest fixes interest upfront and does not decline as principal is repaid.
– Early payoff does not reduce the precomputed interest portion unless the contract explicitly allows it.
– Simple-interest/amortized loans generally reduce interest cost when the borrower makes early payments or additional principal payments.
Checklist — how to protect yourself when comparing loans
– Ask the lender: “Is this add-on interest, simple interest, or amortized?” Get the answer in writing.
– Request an amortization schedule showing each payment’s principal and interest.
– Check the loan contract for prepayment penalties and for language saying interest is not reduced by early payoff.
– Compare APRs and the total finance charge (total amount repaid minus principal).
– Run the numbers yourself: compute total interest using add-on formula, and compare to an amortization calculator result.
– If you have multiple offers, prefer the loan with lower total finance charge and clearer prepayment terms.
How to tell if you’re being charged add-on interest
– The lender’s handout or contract should state how interest is computed. Look for phrases such as “interest calculated on original principal,” “total finance charge,” or a clear example showing interest computed as principal × rate × term.
– If the lender cannot or will not provide an amortization schedule, that is a red flag.
– Comparing the stated monthly payment to a calculation using the add-on formula above will reveal whether the payment matches an add-on schedule.
Can you save money by paying off an add-on loan early?
– Usually no. Because the interest has been fixed and added to principal at the outset, paying early typically does not reduce the predefined interest unless the contract contains a clause that credits early payoff. By contrast, paying extra on a simple-interest (amortized) loan normally reduces future interest.
What is an amortized loan (brief)
– An amortized loan calculates interest each period on the remaining principal balance. Each equal payment contains a shrinking interest portion and an increasing principal portion. Because interest is charged on the outstanding balance, early additional payments reduce the interest you will pay overall.
Practical steps to compare two loan offers
1. Obtain the loan contract and the amortization schedule for each offer.
2. Identify the interest computation method and any prepayment terms.
3. Compare APRs and total finance charges.
4. If needed, plug the numbers into an amortization calculator or spreadsheet to verify total cost over the planned holding period.
Reputable references for further reading
– Investopedia — “Add-On Interest”: https://www.investopedia.com/terms/a/add-on_interest.asp
– Consumer Financial Protection Bureau (CFPB) — “What is simple interest on a loan?”: https://www.consumerfinance.gov/ask-cfpb/what-is-simple-interest-on-a-loan-en-129/
– Bankrate — “Add-on interest definition and examples”: https://www.bankrate.com/loans/personal-loans/add-on-interest-definition/
– Federal Reserve Bank of St. Louis — “What is amortization?”: https://www.stlouisfed.org/open-vault/2014/sep/what-is-amortization
Brief educational disclaimer
This explainer is for educational purposes only and is not individualized financial advice. Always read loan documents carefully and consider consulting a qualified financial counselor or attorney before signing a loan agreement.