The Add-On Method is an interest calculation method for loans in which the total interest is calculated upfront based on the initial principal and divided throughout the loan. The interest amount under this method does not decrease with each payment compared to conventional methods, and thus, this method is unique but expensive for the borrowers.
How the Add-On Method Works
In the add-on approach, interest is determined from the initial amount of principal and is multiplied by the tenure of the loan. The amount of principal and the interest are divided into equal portions, which the borrower pays back over time.
Key Points to Remember:
- Fixed Interest Amount: The interest is determined based on the initial loan amount and remains fixed during the repayment cycle.
- Increased Cost to Borrowers: Because the interest is not recalculated on the lower balance, borrowers pay more than interest compared to conventional methods.
- Lender Profitable: Lenders receive more total interest.
Example:
If ABC took a loan of Rs.10,000 with an annual add-on rate of interest of 10%, the total interest for one year would be Rs. 1,000. Regardless of the outstanding principal at the start of each payment period, ABC would still be paying Rs.1,000 in interest annually.
Conclusion:
The add-on method is favourable to the lender but more expensive to the borrower since there are static amounts of interest charges. Borrowers must know this process when obtaining a loan.
