Add-on Versus APR Interest

If you were to look at a map of the United States you would find an assortment of places containing people and customs that have far reaching roots to other places and other times. No two states have the same laws to protect their citizens. This country is a crazy mixture of laws and rules that change every time you cross a state line. In an attempt to standardize, simplify and clarify the laws pertaining to lending, the legislature of the United States passed a set of laws in 1969 to set-up "Truth In Lending" guidelines to assure that all lenders, no matter where they are located, use the same tools of measurement and disclosure. Terms such as "annual percentage rate" (APR), generally thought of as "Per-diem", made lenders express their interest rates in terms that allowed comparison to other techniques or styles of finance charges. Now, if a lender gave a lowball interest rate but added costs such as "loan processing fees", costs of credit checks, or some other credit related cost he must add all of them to the loan interest amount and then recompute the APR so that they are included in the actual costs of borrowing. Full disclosure is now a requirement. The number of payments, amount borrowed, total interest charged, total amount to be paid (including interest), number of payments, payment amount, time intervals.... all have been addressed by Truth In Lending and must be disclosed appropriately.

Although the FTC requires that all interest disclosures be stated in terms of APR, the actual statutes of the state of Florida allow you to arrive at your maximum interest charge using the "Add-on" method of computing interest. Add-on is actually one of the simplest of the interest methods. You just compute the total interest on the amount borrowed without regard to the repayment schedule. Thus, a loan for a thousand dollars for one year at a 17% add-on rate would come to a total of $1,170. If it were for two years, just multiply the one year interest amount by 2. Simply stated, it is $17 per hundred dollars borrowed, per year. Even though, in theory, the customer will have paid back much of the loan before the first year is over, you still get to charge a full year's interest charge for each of the subsequent years of the loan. This is why Add-on earns as much interest at 17% as per-diem earns at 30.04%. Per-diem charges less interest each time a payment is made because the remaining balance keeps getting smaller.

Add-on not only makes a loan simpler to calculate, it also makes things much simpler when taking a payment. Under "Add-on" you do not need to seperate principal and interest when a payment is made. At inception, all interest charges are precomputed and added on to the amount being borrowed thereby creating one balance which includes both principal and interest. The interest is literally added on to the principal so that when a payment is made, there is no need to seperate them. Just subtract the payment amount from the outstanding balance and repeat the process each pay period until the entire note is satisfied. There are two added responsibilities when you use "Add-on". First, you must recalculate the loan to compute an equivalent APR rate because the FTC requires you to disclose your interest rate in terms of APR even when you use "Add-on" methods. Most computer programs designed for finance do this for you automatically. Second, if the customer wishes to pay-off early, you must reimburse any unearned interest amounts corresponding to the periods being paid-off early. This is actually quite simple. All payoffs of this type are done using "The Rule of 78s". Once again, your computer should do this calculation for you. If not, you may purchase a book of pay-off tables and do them by hand. You must be sure to remember that the state dictates the maximum interest rate according to the age of the vehicle. Consult Florida statute 520 for the exact requirements under the law.

While the maximum interest rate allowed under statute 520 is stated in terms of "Add-on", you could legally use that method to arrive at an equivalent APR and then actually handle the note as a "Per-diem" or APR type loan. Under this method, you do not add the interest to the principal arriving at one combined balance. You must calculate and disclose the interest being charged for each payment. As payments are made, you simply keep the interest and then whatever principal remains must be subtracted from the outstanding balance, thus reducing the balance each time a payment is made. Eventually the note will decline down to nothing, thus "paying out". You are usually not advised to charge an extra late fee for this type of note even though you may technically be allowed, but you should charge the appropriate daily interest rate for any days of lateness. At "pay-off" time, there is no special calculation such as "Rule of 78s" to worry about. You simply compute the interest due since the prior payment and add that to the outstanding balance thus arriving at a final "pay-off" amount.

Having explained the two most popular methods of charging interest, it naturally brings up the question: "Which method should I use?". The answer is not always obvious. Fortunately, most dealers are already using the best method for them, namely Add-on. It's simpler, it maximizes allowable interest, and you don't need to keep separate track of principal and interest on payments. FIADA's Retail Instalment Contract is set-up for Add-on notes. About the only drawback is the fact that you cannot charge additional interest if the customer's lateness causes the note to be extended past its normal expiration date. But, you can charge a Late Fee on any payment that is more than 10 days late. This will generally earn much more profit for you than charging interest on a small remaining balance when a note goes past its expiration date. If the customer becomes late early in the note's life, you may want to re-contract that customer and make his payments more manageable. Otherwise, you should have repossessed the vehicle long ago. There is hardly ever a logical reason for a "large" balance to exist after the normal expiration date of the note. If nothing else, the notice of a late fee tells the customer that you aren't just tolerating his lateness. The FIADA Retail Instalment Contract has a clause in it to advise the customer that he will be assessed a late fee, but it in no way excuses him or gives him permission to do it again. You can still repossess even though you offered forgiveness at an earlier time.

Always remember that no matter which method you use, you still must fully disclose on the contract the exact APR (accurate within 1/8 %) and the amount of interest you are charging.

If a person really wanted to understand interest he would have to research and learn a lot of items. I will mention some of them here but will not attempt to explain all of them for fear of putting you to sleep.

Period... The unit of time between regularly scheduled payments. Usually monthly, but loans may be let as weekly, bi-weekly, etc.. The APR may be divided by the annual number of periods to determine the periodic interest rate.

Annual Percentage Rate (APR)... The annual cost of borrowing stated as a percentage of the amount borrowed. This may be used to calculate interest for the year, period or day.

Periodic charge... Application of the periodic rate against the outstanding balance of the loan. As the loan gets smaller because of periodic payments, it is eventually paid out and thus the sum of all periodic charges is the total amount of interest charged.

Actuarial method... Method of calculating interest earned where the interest earned is added to the outstanding balance at the end of each period whether a payment is made or not.

United States Rule... Method of charging interest earned for time intervals no matter when payments are made. Thus, if a payment were skipped, the interest due is not calculated until a payment if made. At that time, one calculation is made to figure the interest for the number of days since the prior payment. If the payment made was too small to cover all of the interest, the excess amount world normally be carried in a "bucket" or escrow account until another payment is made that is sufficient to cover it. Under no circumstance would the interest be added onto the loan balance such that now a customer would be paying interest on interest.

To return to list of articles: