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