Companies obtain finance from several sources, including equity and debt finance. Equity finance is usually straightforward and comes from shareholders. On this finance, companies may incur costs, such as dividends. However, those costs may be subject to a company making profits. However, the same does not apply to debt finance.

Companies can obtain debt finance from several sources. These may include financial institutions, such as banks, lease companies, or other lenders. On top of that, they can raise debt finance by issuing debt instruments, including bonds. For this finance, the cost primarily consists of the interest payments associated with it.

For most debt finance, the process of calculating and paying interest is straightforward. This value depends on the debt’s principal amount outstanding at the time of payment.

However, some lenders may require a different technique to pay interest. One of these includes add-on interest. Before understanding what it is, it is crucial to discuss simple interests.

What is Simple Interest?

Simple interest is an amount charged on a loan or debt finance based on the principal amount. Borrowers can calculate this amount by multiplying their daily interest rate with the principal and the number of days between payments. Usually, simple interest applies to short-term loans. However, it may also be a part of mortgages or automobile loans.

The process of mearing simple interest is straightforward. Once the borrower establishes the residual principal amount for a loan, they can calculate the interest themselves. This process differs from other complicated interest payment structures that require complex models. Instead, borrowers can use the following simple interest formula.

Simple interest = Principal amount x Daily interest rate x Number of days between payments

The above formula for simple interest provides an accurate value for what the next interest payment will be. Generally, this amount for this interest is fixed or predetermined since all the variables are constant. This interest can be beneficial for both the borrower and lender. However, it may favour the borrower more due to the fixed payments they make.

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Simple interest may apply to various loans and instruments. Most commonly, these are a part of coupon-paying bonds. However, these may also occur in personal loans, for example, home loans, auto loans or mortgages. In contrast, some other loans may use compound interest or the other method of add-on interest mentioned above.

Overall, simple interest is a method of calculating interest payments on loans. This process involves measuring those payments based on the principal amount. Usually, simple interest payments are fixed amounts that borrowers can calculate using the formula above. These payments only apply to specific loans, as mentioned above.

What is Add-On Interest?

Add-on interest is different from simple interest due to its calculation and the amount paid by the borrower. Usually, it involves a complex process of measuring the payments that borrowers must make. Add-on interest requires calculating the interest on a loan by combining the total principal amount and the interest due into a single figure. Therefore, it does not only base its calculations on the loan’s principal value.

Add-on interest requires borrowers to calculate the payments based on a different approach. This method involves adding a loan’s interest to its principal amount. Once the borrower does so, they must divide this amount by the number of months in the loan duration. Based on this calculation, they can determine the amount of the monthly payment they must make.

With add-on interest, lenders use a specific amount of interest to the principal balance when the loan commences. However, it does not use the traditional method of calculating interest payments as in simple interest. Therefore, it does not base its calculations on the remaining principal balance. The interest calculated in this method depends on the interest rate multiplied by the number of years of the loan.

Once lenders calculate this amount, they add it to the principal balance, which constitutes the new principal amount. Therefore, this approach to calculating interest payments involves combining the total loan amount and the total interest due. This amount forms a base, later multiplied by the loan period. The resultant figure divided by the total number of loan payments forms the total periodic payments from the borrower.

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Overall, add-on interest involves a complicated process for calculating the interest and principal payments on loans. This process consists of calculating the interest amount in advance based on the starting principal amount. Regardless of how many principal payments the borrower makes, the interest payment remains the same. Therefore, add-on interest favours the lender more.

How does Add-On Interest work?

Add-on interest provides an alternative method to calculating interest on loans. With this approach, the lender does not base interest calculations on the principal amount. Instead, they calculate the total interest in advance. Therefore, this process does not involve measuring the interest on an ongoing basis based on the residual principal amount.

Lenders use an interest rate or specific dollar amount per $100 borrowed to calculate the interest. Once they get the figure, they multiply it by the number of years in the loan. Then, they add the resultant figure to the loan’s principal amount, which constitutes the new principal balance. Regardless of any subsequent principal or loan payments, the interest does not change on these loans.

With add-on interest, lenders calculate the amount owed at the beginning of the loan contract. This amount depends on the principal borrowed and the annual interest multiplied by the number of years for this contract. Usually, lenders use the following formula to calculate the total amount of interest that the borrower must pay.

Interest = Principal amount x Annual interest rate x Term of the contract

Once they get this amount, they add the principal and interest amounts together. Then, they divide the resultant figure by the total number of payments. Usually, these terms come from the loan contract, which both parties agree to before signing it. Lenders can use the following formula to calculate their periodic payments.

Payment = (Principal amount + Interest amount) / Total number of payments

With this formula, borrowers can understand how much they must pay at the end of each period. As mentioned, the principal amount repaid does not cause any changes to this amount. Therefore, it remains fixed.

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Example

A company, ABC Co., receives a $100,000 loan from a lender for five years. The terms of the loan contract state that the lender will charge an add-on interest on this loan. Furthermore, it specifies that the interest rate on it will be 10% annually. The contract also requires ABC Co. to repay the loan in monthly installments. Based on this information, the calculation of add-on interest will occur as follows.

Firstly, the lender will calculate the annual interest on the loan. As mentioned, this step will involve multiplying the interest rate on the loan contract with the amount ABC Co. borrowed. Similarly, it will include the total period of the loan in the calculation. The lender calculates the interest on the loan as follows.

Interest = Principal amount x Annual interest rate x Term of the contract

Interest = $100,000 x 10% x 5 years

Interest = $50,000

Next, the borrower will add this interesting figure to the principal amount. Then, they will determine the periodic payments by dividing the resultant amount by the total number of periods. Since the loan spans over five years and requires monthly payments, these payments will occur 60 times. Therefore, the payment calculation will be as follows.

Payment = (Principal amount + Interest amount) / Total number of payments

Payment = ($100,000 + $50,000) / 60

Payment = 2,500/month

Conclusion

Lenders may use several methods to calculate the interest payments on their loans. Usually, they use the simple interest method, which is straightforward. However, they may also apply add-on interest.

This process involves calculating the interest payments in advance. Once they do so, they divide the sum of the resultant figure and principal amount by the total number of payments. This calculation will provide them with a payment figure, which they will receive each period.