add-on interest

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Add-On Interest

A method of determining interest in which the interest is calculated as a percentage of the original principal. For example, if one borrows $10,000 at an annual add-on interest rate of 10%, the interest one pays each year is $1,000 (10% of $10,000), regardless of how much principal remains at the beginning of each payment period. Using add-on interest will result in more interest paid and, as a result, higher monthly payments.

add-on interest

An interest calculation sometimes used to avoid state usury laws (prohibitions against excessive interest) or to gain the equivalent of a prepayment penalty not otherwise allowed by law.The interest for the entire term of the loan is calculated as if no payments will be made until the loan matures.The total interest is added to the principal, and the borrower then makes equal monthly payments over the term of the loan. Even though the borrower reduces the outstanding principal balance with each payment, he or she is still paying interest on the whole amount borrowed. If the borrower prepays the loan, a calculation called the rule of 78s results in a disguised prepayment penalty.

Example:  The difference between 8 percent simple interest and 8 percent add-on interest for a $25,000 loan paid monthly for 4 years is

Simple interest monthly payments          =             $610.32

Simple interest total interest paid           =           $3,586.62

Add-on interest monthly payments         =             $687.50

Total add-on interest paid                      =         $8,000.00