The Add-on Method: A Simple Finance Charge Calculation

The add-on method is a straightforward approach to calculating finance charges, often used in loans and installment plans. It’s considered simple because the interest is calculated on the original principal amount and then added directly to it to determine the total amount to be repaid.

How it Works

The core principle is quite basic. First, the interest amount is calculated based on the principal amount, the interest rate, and the loan term. This interest amount is then added to the principal, resulting in the total amount owed. This total is then divided by the number of payment periods to determine the periodic payment amount.

Here’s the formula:

Total Interest = Principal x Interest Rate x Time (in years)

Total Amount Owed = Principal + Total Interest

Periodic Payment = Total Amount Owed / Number of Payment Periods

Example

Let’s say you borrow $5,000 at an interest rate of 8% per year for a term of 3 years. Using the add-on method:

Total Interest = $5,000 x 0.08 x 3 = $1,200

Total Amount Owed = $5,000 + $1,200 = $6,200

Monthly Payment (assuming monthly payments) = $6,200 / 36 = $172.22 (approximately)

Advantages and Disadvantages

Advantages:

• Simplicity: It’s easy to understand and calculate.
• Predictable Payments: The periodic payment remains constant throughout the loan term.

Disadvantages:

• Higher Effective Interest Rate: The effective interest rate is actually higher than the stated rate. This is because the interest is calculated on the original principal amount, even though you are gradually paying down the principal. As you repay, you are still paying interest on the original full amount.
• Less Transparency: The add-on method can sometimes obscure the true cost of borrowing, as the simple interest calculation may seem lower than the effective rate.
• Not Commonly Used: It is less prevalent than other methods, like the simple interest method, especially for larger loans or mortgages.

Considerations

While the add-on method provides a simple way to calculate payments, borrowers need to be aware that the effective interest rate is higher than the stated rate. Always compare different loan offers using the Annual Percentage Rate (APR), which includes all costs of borrowing, to get a true picture of the expense.