In the finance industry, the term add-on loan has two slightly different but related definitions. In the first application of the phrase, the projected interest for the length of loan is assessed and added to the principal of the loan. In the second case, a percentage of said interest or a specific dollar amount is assigned to each payment to go specifically toward paying interest.
The major disadvantage of an add-on loan is the inability to pay off or pay down the loan early. In short, when a borrower chooses this type of loan with the expectation of a ten-year payoff schedule, he or she will be assigned ten years of interest. If circumstances allow full repayment after three years, the borrower will end up paying interest for those additional seven years anyway.
In addition, the annual percentage rate (APR) of an add-on loan is effectively much higher than loans with simple interest structures. This is because add-on loans do not consider declining principal. In simple loans, the amount of interest assessed each month reduces in conjunction with the principal owed. Add-on loans presume that a borrower owes the same amount of interest with the first payment as with the last.
An add-on loan by definition is a fixed-rate loan. This can be an additional disadvantage if the loan is taken out at a time with a high APR. Here, the compound effect of interest rates would be an inflated effective APR assessed on an already high base interest rate. The cumulative interest could easily add significantly to even a small loan.
The disadvantages of an add-on loan are most evident in long-term loans. In an extremely short-term loan, factors such as predictability of monthly payments and ease of calculation may outweigh the drawbacks of this type of loan. In long-term loans, such as mortgages or car loans, careful consideration of other loan options is strongly advised.
Many consumers may find the calculation of the effective annual percentage of an add-on loan daunting. Borrowers should be aware that, regardless of what interest structure is chosen, most federal and local governments require that lenders provide both the actual APR and the effective APR before the signing of the lending agreement. Furthermore, completing a loan application does not necessitate the final acceptance of the terms. In short, if the terms of any loan document are unacceptable, a borrower is free to look elsewhere for a more palatable situation.