Reducing Balance vs Add-On Loan
Which One Costs More – Reducing Balance or Add On?
I was recently a guest on the Earning Season Podcast and I spoke about the journey towards home ownership, which included everything from applying for a loan, to searching for a house to what to expect as a new home owner and I also spoke about my thoughts on whether or not Jamaica is in a housing bubble. Something important came up that I thought I’d write about. We were discussing the difference between ‘reducing balance’ and ‘add-on’ methods of calculating interest and Randy, one of the show’s hosts, stated that you should never get a loan from somewhere that is giving you the latter (He also had an interesting rant about an institution he once got an add-on loan from but listen to the podcast to hear it in full). So why did he say that?
Some lenders will attract customers with an add-on loan because the terms of those loans are usually more appealing i.e. the processing time is lower and the paperwork/documentation required is much less. There’s a saying in the world of finance that goes ‘there is no such thing as a free lunch.’ The reason why they make the process easier and they can provide you with a loan in minutes is because if you get a loan with add-on interest you are typically going to end up paying more than if you got one with a reducing balance. Many places do not advertise how interest is calculated and you most likely would not even think to ask. Money is money right? Well since you follow this blog, I am equipping you with the tools on what to ask in regards to interest calculations if you ever seek out a loan (especially an unsecured loan/personal loan/payday loan) in Jamaica.
Let’s start with an example of what you would pay if all else was equal with the two methods:
So the difference between Reducing Balance and Add-On is $3,613.89, which may not be a big deal, but think about if it was $1 million dollars, the difference would be $36,138!
If you really think that the cost of getting the loan quickly is worth $3,600, there is also another major consideration. What most people don’t know or realise is that when you are charged add-on interest, if you get the loan today and you decide to repay it tomorrow, you are going to be charged the entire amount of interest that you originally agreed to. In the example above that would be $8,000.
Conversely, a reducing balance loan, as the name suggests, will see reductions in the principal balance as you make payments and over time your interest payment is calculated on the reduced balance. This is why in the previous example you only pay $4,386.11 in interest. If you choose to pay the loan off early or refinance the loan, then you would be at an advantage because you would have paid off more of the principal loan amount with a reducing balance loan than with an add-on loan.
Here’s an example of what the amount to pay off the loan is after 1 month, 3 months and 6 months for the previous $100,000 loan at 8% for reducing balance vs add-on:
So in essence with all things equal, a reducing balance loan is always better because you pay less in interest. If you never thought to ask before and are planning to access a loan in the future, be sure to ask how the loan is calculated and whether or not its reducing balance or add-on. You may still decide to go with the add on based on your circumstance, but just be aware that if you have an option a reducing balance loan will save you a lot in the long run.
Visit my loan calculators here: http://financialcentsibility.com/calculators/