Key Principle
The stated interest rate equals the true cost only under simple interest. Every other method -- discount and add-on -- inflates the actual cost through different mechanisms, and the only reliable comparison tool is APR. "The APR and the stated rate of interest are equivalent... This is always the case when the simple interest method is used to calculate finance charges." (p. 240)
Why This Matters
Borrowers routinely compare loans by stated rate and pick the lower number, unaware that different interest calculation methods can make a "lower" rate far more expensive. A 6.5% add-on loan costs more than an 8% simple interest loan. A discount loan at 8% actually charges 9.52% APR. Without understanding these methods, consumers systematically select costlier credit. The add-on method is the single most important thing to screen for when shopping installment loans, because a small difference in monthly payment ($90 vs. $87) masks a near-doubling of the true interest rate.
Good Examples
- Discount method trap: A $1,000, 2-year, 8% discount loan deducts $160 upfront. The borrower receives only $840 but repays $1,000. The APR is 9.52% -- nearly 20% above the stated 8%. (p. 241)
- Add-on vs. simple interest: On identical $1,000, 8%, 12-month loans, add-on charges $80.00 in finance charges (APR 14.45%) while simple interest charges $43.88 (APR 8.00%). Add-on produces 82% more in finance charges. (pp. 243-246)
- The 6.5%-that-costs-12% problem: Aaron Woods faces a 6.5% add-on loan vs. an 8% simple interest loan on $6,500 for 36 months. The add-on APR is near 12%, far exceeding the bank's 8% simple interest rate. (pp. 252-253)
Counterpoints
- Rule of 78s hidden penalty: Even without an explicit prepayment penalty, the Rule of 78s front-loads interest so borrowers who pay off early owe more than expected. On a $1,000 add-on loan paid off at month 6: $518.46 under Rule of 78s vs. $509.97 under simple interest. The gap grows with larger loans and longer terms. "The rule of 78s benefits the lender at the expense of the borrower." (p. 246)
- Discount proceeds shortfall: A borrower who needs $25,000 for tuition and takes a $30,000 discount loan at 8% receives only $25,200 after the $4,800 interest deduction -- the loan may not deliver enough cash. (p. 252)
- Borrow vs. pay cash is not intuitive: The correct comparison is after-tax borrowing cost vs. after-tax interest earnings lost. "If it costs more to borrow the money than the interest you would lose by withdrawing from savings, pay cash; if not, you should probably take out a loan." (p. 248)
Key Quotes
"Sometimes what you see is not what you get -- such as when you borrow money through a discount loan and end up paying quite a bit more than the quoted rate." (p. 241)
"Add-on loans are very expensive. Indeed, they generally rank as one of the most costly forms of consumer credit, with APRs that are often well above the rates charged even on many credit cards." (p. 245)
"When you're taking out an installment loan, be sure to find out whether simple or add-on interest is being used to compute finance charges. And if it's add-on, you might want to consider looking elsewhere for the loan." (p. 245)
"Similar loans with the same stated interest rates may have different finance charges and APRs." (p. 238)
Rules of Thumb
- The APR on an add-on loan is approximately double the stated rate
- Never compare loans by stated rate; compare only by APR
- Simple interest is the only method where stated rate = true rate -- treat it as the benchmark
- When the borrow-vs-cash cost spread is small (~$100 on a $1,500-$2,000 loan), borrowing to preserve liquidity is legitimate
- Home equity loans can flip the borrow-vs-cash decision because interest may be tax-deductible
- Avoid credit life insurance -- it is "very costly and does little more than give lenders a lucrative source of income" (p. 246)
Related References
- Behavioral Traps and Credit Dangers - add-on method exploits anchoring bias; monthly payment focus obscures total cost
- Credit Problems, Fraud, and Bankruptcy - loan rollover and refinancing consequences
- Student Loan Programs - student loan rate structures and repayment mechanics