Experts at Carleton acknowledged calculating add-on interest isn’t as prevalent as it once was with finance companies and other lenders using simple-interest calculations more often nowadays.

However, to help companies keep their calculations straight, Carleton recently offered guidance so managers can better understand both interest approaches.

“Over the years, different methods of calculating interest have been used in the consumer finance industry, each affecting both payment calculations and interest calculations. State guidelines differ in the way they describe interest rates, and in turn how they judge the total charge allowed for a consumer credit transaction,” Carleton wrote in a company blog post.

“Simply put, a 10% add-on interest rate is not equivalent to a 10% simple interest rate. Because of the underlying definitional assumptions, these rates are inherently unequal,” Carleton continued.

Experts explained that add-on interest is a method that calculates interest on the initial loan balance rather than on the outstanding principal. In this structure, Carleton said the lender calculates the total interest due at the beginning of the loan and “adds” it to the principal balance. The result is then divided by the number of payments, giving borrowers equal monthly payments over the term.

If the consumer pays the loan off early, Carleton said the consumer is due a refund. Add-on interest is a linear calculation, according to company experts.

Meanwhile, in a simple interest loan, Carleton said the lender calculates interest daily based on the remaining principal.

Experts explained the calculations are computed up front, but the principal and interest balance will vary over the life of the loan based on the repayment.

If the consumer pays a loan off early, Carleton indicated there is generally no refund required because the interest has only been assessed and paid for days actually elapsed, not for the entirety of the loan.

“Add-on interest was once more common than it is today, particularly in consumer installment loans. The appeal was its simplicity: the calculations were far more straightforward,” Carleton said, while explaining that standard Interest equals principal times rate times the time calculation.

“Additionally, it could be done using paper and a pencil in front of a customer to arrive at a total charge for credit. The fixed payment structure was easier to compute, remember, and understand. Today, only a few states still use add-on interest as their method for evaluating maximum rates,” Carleton continued.

“Simple interest has become the predominant method for calculating interest in consumer credit. Historically, add-on interest was favored for its simpler math, but advancements in computing power have eliminated the need for such simplifications. Modern software easily handles more complex amortization schedules, accurately reflecting daily interest accrual,” Carleton went on to say.

Carleton closed with these four takeaways:

—Add-on interest loans give borrowers a fixed monthly payment.

—Simple interest loans provide flexibility and account for daily accrual.

—With today’s computing power, add-on interest has become largely a thing of the past.

—As states continue to use language in their statutes that reference add-on interest rates, it is important to understand the key differences in these interest types.