Legal Definitions - add-on interest

Add-on interest is a method of calculating interest on a loan where the total interest for the entire duration of the loan is determined at the outset and added to the original principal amount. The borrower then repays this combined sum (principal + total interest) in equal installments over the loan term. A key characteristic of add-on interest is that the interest portion of each payment remains constant throughout the loan, even as the principal balance decreases. This method often results in a higher effective annual percentage rate (APR) compared to loans where interest is calculated on the declining principal balance.

• Example 1: Car Dealership Financing
  A customer purchases a new vehicle and finances $25,000 over 60 months (5 years) at a stated 6% add-on interest rate. The total interest is calculated as 6% of $25,000 per year for 5 years, which amounts to $1,500 per year multiplied by 5 years, totaling $7,500. This $7,500 is immediately added to the $25,000 principal, making the total amount to be repaid $32,500. The customer then makes 60 equal monthly payments of $32,500 divided by 60, resulting in approximately $541.67 per month.

  How it illustrates the term: This example demonstrates how the entire interest amount ($7,500) is calculated upfront based on the original principal and the full loan term. This fixed interest is then "added on" to the principal to determine the total repayment sum, which is subsequently divided into equal installments. The interest component of each payment remains the same, regardless of how much principal has already been paid down.

• Example 2: Retail Store Installment Plan
  A consumer buys a new living room set for $3,000 and opts for an in-store financing plan over 36 months with an 8% add-on interest rate. The total interest for the three years would be 8% of $3,000 per year for 3 years, which is $240 per year multiplied by 3 years, totaling $720. This $720 is added to the $3,000 principal, meaning the total repayment is $3,720. The consumer then pays $3,720 divided by 36 months, resulting in $103.33 per month.

  How it illustrates the term: In this scenario, the interest ($720) is pre-calculated on the initial loan amount for the entire 36-month period and immediately combined with the principal. The monthly payment is then derived from this fixed total, clearly showing the "add-on" nature of the interest calculation where the interest is not recalculated as the principal decreases.