What is add-on interest?
Add-on interest is the extra interest added to the regular interest charges on a loan, credit card, or mortgage. It’s a way for lenders to make more money on the money they lend out. However, add-on interest can make borrowing more expensive and increase the total amount someone has to pay back.
How does add-on interest work?
With add-on interest, the lender calculates the total interest charges for the entire loan term. Then, they add this interest amount to the original amount borrowed (called the principal). This new, larger amount is divided into equal payments over the loan’s term.
So, let’s say you borrow $1,000 at an add-on interest rate of 10% for one year. The lender calculates that the total interest over that year will be $100 (10% of $1,000). They add that $100 to your original $1,000 loan, so now the total is $1,100. If you’re making monthly payments, that $1,100 gets split up into 12 equal payments of about $91.67 each.
This is different from other types of interest, like simple interest, where you only pay interest on the amount you still owe. With add-on interest, you’re paying interest on the whole original loan amount, even as you pay the loan down over time.
The downsides of add-on interest
Add-on interest might sound okay at first. After all, you know right from the start what your total borrowing costs will be. But there are some big downsides to watch out for:
Higher total borrowing costs
With add-on interest, you end up paying interest on money you’ve already paid back. So, your total borrowing costs are higher compared to simple interest loans. Even if two loans have the same stated interest rate, the one with add-on interest will cost you more.
Harder to pay off early
Paying off a loan early is usually a smart money move. You save on interest charges and get out of debt faster. But with add-on interest loans, you don’t get as much benefit from paying early. Since your total interest charge is set from the beginning and factored into every payment, you’ll pay most of that interest even if you pay the loan off early. You don’t get rewarded with as much savings for being a responsible borrower.
Disguises the true interest rate
Seeing an add-on interest rate can trick you into thinking you’re getting a better deal than you really are. A loan with 10% add-on interest might sound similar to one with 10% simple interest, but it’s actually much more expensive.
To really compare apples to apples, you need to convert the add-on interest rate to an annual percentage rate (APR). The APR shows what you’re really paying to borrow money for a year, including fees. The APR for add-on interest is always much higher than the stated add-on rate.
Where you might see add-on interest
Thankfully, add-on interest isn’t super common for big, mainstream loans these days. Most standard mortgages, car loans, student loans, and credit cards use simple interest instead.
But you still might run into add-on interest in places like:
- Payday loans and other short-term loans aimed at people with bad credit
- Some furniture, appliance, and electronics financing offers
- Certain “buy here, pay here” car lots that do their financing
- A few older credit cards that are still using add-on interest calculations
What to do if you’re considering an add-on interest loan
Before you sign on the dotted line for any loan, make sure you know what kind of interest you’re being charged. If it’s an add-on interest, take extra time to understand what you’re getting into.
Ask the lender for the loan’s APR so you can better compare it to other options. Run the numbers to see how much you’ll pay on the add-on interest loan vs. a simple interest loan. Factor in whether you think you’ll want to pay the loan off early.
In many cases, you’ll find that an add-on interest loan is the most expensive way to borrow. Even if you have bad credit, it’s worth shopping around for alternate financing. Credit unions, online lenders, secured credit cards, and asking someone to co-sign a loan are all possibilities to explore.
If you do end up with an add-on interest loan, prioritize paying it off as quickly as you can. See if your budget has any extra room for making additional payments to the loan. Getting that loan paid off faster will help you save at least a little on interest. Then, you can put those payments toward your other financial goals.
The bottom line
Add-on interest loans aren’t the most friendly way to borrow. You’ll usually pay more in interest and have a harder time paying off your debt early. Add-on interest disguises the true cost of borrowing, which is why most big lenders have moved away from it.
But add-on interest still pops up in some corners of the lending world. If you’re considering a loan with add-on interest, be extra cautious. Compare that loan to other options using the APR to see the real cost. Chances are, you can find a more affordable way to borrow. And if you do take out an add-on interest loan, try to pay it off quickly to minimize the total interest you’ll pay.
Borrowing money is a big responsibility. Having as much knowledge as possible makes it easier to be a smart, responsible borrower. Knowing how add-on interest works puts you in a better position to make good borrowing decisions and reach your financial goals faster.
