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What is an add-on interest loan?
An add-on interest loan is a loan where the interest has been calculated at signing and added to the principal to make one single balance. Rather than make periodic payments against discrete interest and principal amounts, borrowers of an add-on interest loan make payments against the principal, which includes the interest amount.
Conventional loans accrue interest based on the balance left on the loan at the end of each payment cycle. This is called simple interest. Over time, borrowers may owe more interest if they don’t meet their payment obligations, but they could also owe less if they pay off the principal sooner than the maturity date of the loan.
With an add-on interest loan, it’s not possible to avoid paying less interest because the interest has already been added to the principal from the start. Each payment the borrower of an add-on interest loan makes against the loan goes toward the principal, which the interest she’d normally pay is baked into. Lenders make the add-on interest calculation when the loan is approved, using two formulas:
Interest = Principal x Annual Interest Rate x Term
Payment = (Principal + Interest) / Total Number of Payments
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Add-0n interest loan example
Carlysle takes out a $100,000 loan to buy an ultra-high-end 4K TV. The loan is an add-on interest loan with an interest rate of 4 percent and a term of four years. The amount of interest the loan accrues is $16,000, or 100,000 x 0.04 x 4. Carlysle’s monthly payments look like this: 116,000 / 48, or about $2,417 per month.