What is add-on interest?
Add-on interest is a type of interest that is calculated at the start of a loan. It is then applied to the principal, or amount borrowed. This form for interest ensures that all interest is repaid even if the borrower pays off the loan earlier than the expected due date.
Add-on interest is a calculation method used when obtaining a mortgage or loan. In this method, the interest payable on the loan is calculated at the start of the loan. Once the interest is calculated, it is then added to the principal. When the borrower pays off the loan, he is paying off both the interest and principal.
Some financial institutions prefer add-on interest instead of conventional interest because if the borrower pays her loan off early the bank will still get its full interest payment. With add-on interest factored in prior to when the payments begin, the borrower must pay all of the interest as if the loan had been carried to its full-term length.
It is not common for this type of interest to be used in consumer loans, but it can occur. In most cases, this type of financing is done between financial institutions or for business loans.
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Add-on interest example
Ramin obtains a loan for $1,000, and that loan is due to be paid in two years with an interest rate of 9 percent. With add-on interest, the principal is calculated by multiplying $1,000 by 9 percent and adding the amount back to $1,000, making his total principal $1,180. Ramin will pay $590 each year.