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What’s add-on interest on a loan?
The sneaky way short-term lenders charge more to bad-credit borrowers.
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.
What is add-on interest on a loan?
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.
Why should I avoid add-on interest?
There are two main reasons to stay away from add-on interest:
- It’s more expensive. Add-on interest makes the loan more expensive than your standard, simple interest rate.
- You can’t save by paying off the loan early. If you decide to pay off your loan early, you can’t save on interest — it’s already been added to the balance.
What types of loans come with 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.
How to calculate add-on interest
There are two steps to calculating add-on interest and coming up with your repayment:
1. Calculate the total cost of interest.
This is the formula lenders use to calculate the total interest charge on the loan:
- Principal balance x Annual interest rate x Loan term in years =Total interest cost
Let’s take a look at an example …
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.
2. Calculate the repayment amount based on the interest cost.
After the lender has the total interest cost, lenders use this formula to calculate your repayment amount:
- (Principal balance + Total interest cost) / Total number of repayments = Repayment amount
Let’s take a look at an example …
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.
How do other interest rates work?
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.
- Simple interest. Lenders calculate simple interest each payment cycle based on the current balance. Our monthly repayment calculator is based on the simple interest formula, which is the most common.
- Compound interest. Here, interest adds up each day, based on your balance and any unpaid interest since the last repayment. It’s more common with savings accounts than loans.
Example: Add-on vs. simple interest
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:
Total interest cost
The add-on interest loan costs about $1,960more in interest than the simple interest loan.
Why do lenders charge add-on interest?
There are three main reasons lenders charge add-on interest with personal loans:
- Sounds cheaper than it is. A lender can advertise an interest rate and earn thousands more than they would have if they charged simple interest at that rate. And a borrower might not know the difference.
- Get around APR limits. States often have regulations on the interest rate a lender can charge — but don’t specify what type of interest.
- Avoid prepayment loss. Add-on interest ensures the lender gets the full return on its investment, regardless of whether you pay off the loan early.
How do I avoid add-on interest?
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.
Compare top lenders that don’t charge add-on interest
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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