Thread by @MsGillyJ

What's the difference between a reducing balance loan & an add-on loan?

For a $100,000 loan at 8% over 1 year the difference is $3,600. It may not seem like a lot but stick with me to understand why you should ask the question on how interest is calculated for a loan

A thread

I was recently a guest on @Earnings_Season Podcast & 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 & my thoughts on whether or not Ja is in a housing bubble
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Something important came up that I thought I’d talk about. We were discussing the difference between ‘reducing balance’ and ‘add-on’ methods of calculating interest and @rtrowe stated that you should never get an add-on loan, (He had an interesting rant about this) but why?

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Some lenders will attract customers with an add-on loan because the terms of those loans are usually more appealing, the processing time is lower & less paperwork. There’s a saying in the world of finance that goes ‘there is no such thing as a free lunch.’
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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.

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Many places don't advertise how interest is calculated & you most likely would not even think to ask. Money is money right? Well since you follow #FinanceTwitterJa I am equipping you with the tools on what to ask if you ever seek out a loan (esp. unsecured/personal/payday loan) 6

So an example:

What you would pay if all else was equal with the two methods?

The difference between Reducing Balance and Add-On is $3,613.89 in this example, which may not be a big deal, but think about if it was $1 million dollars, the difference would be $36,138!

You may think that the cost of getting the loan quickly is worth $3,600, but 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..

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..you are going to be charged the entire amount of interest that you originally agreed to for an add-on loan. In the example above that would be $8,000.

Conversely, for a reducing balance loan as you make payments the outstanding interest is calculated on the reduced balance. 9

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 have paid off more of the principal loan amount with a reducing balance loan than with an add-on loan.

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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.

In essence with all things equal, a reducing balance loan is always better because you pay less in interest. 11/

If you never thought to ask before & are planning to access a loan in the future, be sure to ask how it 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 of the diff. /12

See the full post on my blog about reducing balance vs add-on here:

financialcentsibility.com/reducing-balan…

and see my loan calculators here:  financialcentsibility.com/calculators/

#financetwitterJa

For a 25% loan (which is more typical) the difference is $10,200.