Thursday, May 30, 2013

Add-on Rates Revisited


Dear Investor Juan,

I just got a loan for 450k 36months to pay.. I see a per annum rate of 28.58% but she was saying something about 1.29% per month add on rate.. Im confused, mind explaining it to me the add on rate?


Dear Mon,

I have already discussed the difference between add-on rate and the monthly compounded interest rate (such as in credit card debt or home and car loans) in this post, but I will try to explain in again and apply it to your situation.

With add-on interest, the quoted monthly add-on interest rate is multiplied to the principal or loan amount to get the monthly interest payment. For the monthly principal repayment, the loan amount is divided by the loan duration. In your case, therefore, the monthly interest payment is 1.29%*450,000 = 5,805, while the monthly principal repayment is 450,000/36 = 12,500, and the total monthly payment is 5,805 + 12,500 = 18,305, an amount that you would have to pay every month, as seen in the spreadsheet below. If you scroll down to the bottom of the sheet, you'll see that at the end of 36 months, you will have paid a total of 658,980, of which 208,980 is for interest. Further down, you'll see that the internal rate of return or IRR, a way to compute for return or interest while considering the timing of payments, is 26.72%. This is not exactly what your bank representative quoted, but this may be what she was talking about.

Now if we were to take the same monthly interest rate of 1.29% but this time apply it as a monthly compounded rate in an amortized loan, then we'll see a different payment schedule. Please refer to the spreadsheet below.

To get the monthly payment (or "amortization") of this kind of loan, we have to use the PMT function of Excel or any spreadsheet program, where "rate" = 1.29%, "nper" = 36, and PV = -450,000. The resulting figure is 15,705, which is the amount that is paid every month until the 36th month. In the first payment, 1.29%*450,000 = 5,805 goes to interest, same as in the add-on loan, so 15,705 - 5,805 = 9,900 goes to principal. The following month, the principal goes down to 450,000 - 9,900 = 440,100, which will then become the basis for this month's interest payment of 440,100*1.29% = 5,677. Do you now see how this kind of loan is different from your add-on loan?

With monthly compounded interest loans, principal repayments are deducted from the principal, the lower principal balance becomes the basis for interest computation, and interest payments decline (and in the case of amortized loans where the monthly payment is constant, principal payments increase) as the end of the loan period nears. With add-on interest, monthly interest payments stay the same even as part of the principal is repaid every month. And this is why, at the same "monthly interest rate," add-on interest loans are more expensive than monthly compounded debt.

I hope I was able to explain the add-on rate sufficiently, Mon. Good luck.

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