Understanding Add-On Interest vs. Simple Interest

 

When it comes to consumer finance, the application of an interest rate is a core factor affecting the soundness of the calculations. But not all interest rates are alike!

Over the years, different methods of calculating interest have been used in the consumer finance industry, each affecting both payment calculations and interest calculations. State guidelines differ in the way they describe interest rates, and in turn how they judge the total charge allowed for a consumer credit transaction.

Simply put, a 10% add-on interest rate is not equivalent to a 10% simple interest rate. Because of the underlying definitional assumptions, these rates are inherently unequal.

Below, we explore the differences between these two interest calculations.

 

What Is Add-On Interest?

Add-on interest is a method that calculates interest on the initial loan balance rather than on the outstanding principal. In this structure, the lender calculates the total interest due at the beginning of the loan and “adds” it to the principal balance. The result is then divided by the number of payments, giving borrowers equal monthly payments over the term. If the consumer pays the loan off early, the consumer is due a refund. Add-on interest is a linear calculation.

 

What Is Simple Interest?

In a simple interest loan, the lender calculates interest daily based on the remaining principal. The calculations are computed up front, but the principal and interest balance will vary over the life of the loan based on the repayment. If the consumer pays a loan off early, there is generally no refund required because the interest has only been assessed and paid for days actually elapsed, not for the entirety of the loan.

 

Historical Context

• Add-on interest was once more common than it is today, particularly in consumer installment loans. The appeal was its simplicity: the calculations were far more straightforward, relying on the standard Interest = Principal x Rate x Time calculation. Additionally, it could be done using paper and a pencil in front of a customer to arrive at a total charge for credit. The fixed payment structure was easier to compute, remember, and understand. Today, only a few states still use add-on interest as their method for evaluating maximum rates.

• Simple interest has become the predominant method for calculating interest in consumer credit. Historically, add-on interest was favored for its simpler math, but advancements in computing power have eliminated the need for such simplifications. Modern software easily handles more complex amortization schedules, accurately reflecting daily interest accrual.

 

Add-On Interest vs. Simple Interest: How It's Calculated

• Add-On Interest: This is calculated periodically—typically on a monthly basis—meaning there is no daily adjustment for the declining principal.
  • Add-on interest differs from simple interest, where the interest accrues daily on the remaining loan balance.
  • This straightforward approach requires minimal adjustments or calculations after loan origination unless the loan is paid off early.

 

• Simple Interest: In a simple interest loan, interest accumulates based on the loan’s principal balance each day.
  • This daily calculation reflects the actual balance of principal plus interest that a borrower owes at any given time.
  • Since the principal balance changes daily as payments are applied, lenders must use a more iterative process to calculate interest and principal over the life of the loan.
  • This complexity can require more sophisticated calculation systems to ensure that each payment is applied and interest is calculated correctly.

 

Terminology Examples

• Add-On Interest: “$10 per $100 per year.”¹

• Simple Interest: “twenty-five percent (25%) per year.”²

 

Key Takeaways

• Add-on interest loans give borrowers a fixed monthly payment.

• Simple interest loans provide flexibility and account for daily accrual.

• With today’s computing power, add-on interest has become largely a thing of the past.

• As states continue to use language in their statutes that reference add-on interest rates, it is important to understand the key differences in these interest types.

 

 

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¹ Fla. Stat. § 520.08(1)(a)

² IN Code § 24-4.5-6-201