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Add-on interest is one of the most expensive ways to calculate interest out there. It’s not common on most types of loans. But some short-term lenders use this formula to get around state laws and offer loans that look cheaper than they really are.
Add-on interest is an interest formula where the lender calculates and adds interest to the loan amount — or principal — when you sign the contract. Then it divides the new balance into monthly, weekly or daily repayments over your loan term. It’s closer to charging a flat fee rather than interest.
It’s also known as precalculated or precomputed interest — though these terms are more common with car loans than personal loans.
There are two main reasons to stay away from add-on interest:
Add-on interest is most common with short-term loans, like installment loans. You also might find it with loans geared toward borrowers with bad credit, including car loans. But generally, it’s the most common on loans between banks, not consumer loans.
There are two steps to calculating add-on interest and coming up with your repayment:
This is the formula lenders use to calculate the total interest charge on the loan:
Say you had a $10,000 loan with an annual interest rate of 30% and a loan term of 18 months, or 1.5 years.
Here’s how you’d calculate the interest rate:
$10,000 x 30% = 3,000
$3,000 x 1.5 = $4,500
The total interest cost is $4,500.
After the lender has the total interest cost, lenders use this formula to calculate your repayment amount:
Say that loan came with monthly repayments over its 18-month term. This is how you’d calculate the repayment amount each month:
$10,000 + $4,500 = $14,500
$14,500 / 18 = $805.56
The monthly repayment is $805.56.
Other interest rates add up over time, rather than being precalculated. This means that the amount you pay in interest decreases as you pay off the loan.
Let’s take a look at the difference between add-on and simple interest on a personal loan — using the same loan amounts, rates and terms from before. Here’s how they compare:
Loan amount | $10,000 | $10,000 |
Rate | 30% | 30% |
Term | 18 months | 18 months |
Monthly repayment | $805.56 | $696.70 |
Total interest cost | $4,500 | $2,540.61 |
The add-on interest loan costs about $1,960more in interest than the simple interest loan.
There are three main reasons lenders charge add-on interest with personal loans:
If it’s not clear how a lender calculates interest, ask before you apply. You generally don’t need to ask if you’re taking out a personal loan. But with an installment loan or another bad-credit product, that question could save you thousands.
Stay away from add-on interest if you can — you’ll have higher monthly repayments, a higher total loan cost and you can’t save by paying it off early. Learn more about how short-term loans work and compare lenders with our guides.
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