“I’m a little confused about the difference between loans that are paid back on the reducing balance and loans that say add-on. I’m comparing mortgages from different companies in order to buy a house, and I want to ensure that I get the best deal. Please advise me.”

It’s not an easy task for the average consumer to comprehend how loans are calculated. You could probably call four institutions and ask for the same quote and receive four different repayment amounts, depending on how they compute their loans.

When you are looking at loan options, it’s important to ensure you are comparing apples with apples. The true cost of a loan can include commitment fee charges and insurance costs, which would vary across the companies.

In fact, in the United States where lending institutions abound, it is required by law that a standardized computation to compare loans, called the Annual Percentage Rate (APR), be used in loan advertisements, along with the interest rate stated on the loan contract.

According to www.answers.com, APR is defined as ‘the annual rate that is charged for borrowing, expressed as a single percentage number that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction.’

In Jamaica, although there are different types of loan calculations that can leave consumers unsure of what they are really getting into when they borrow, it’s not the practice to use APR when comparing loans. However, there are other ways that the consumer can get a better understanding of the loan facility they are applying for. S

ome key questions to ask are: ‘Is the loan on the reducing balance?’, ‘Is there a penalty for early repayment?’ ‘What percentage commitment fee do you charge?’ ‘Are there charges for late repayment?’

The idea is to unearth any hidden penalties or charges that may not be so obvious from the advertisements, and also to determine which loan gives you the lowest interest repayment option.

Let’s look at two types of loan calculations that are common in Jamaica- Add-on Method and Reducing Balance method.

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Add-on Method

In this type of calculation, the interest costs are calculated by adding the total interest payable over the life of the loan to the original loan principal, which is the amount you wish to borrow. Therefore, your effective principal includes the interest rate due (hence ‘add-on’). Here’s a simple formula to calculate interest using this method:

Add-On Interest = Principal x Interest Rate x Number of Months in the loan / 12.

The principal repayment due is computed by dividing the original principal into a number of months for payback according to the terms of the loan. The total fixed repayment is made up of the interest charges plus the principal repayment.

Here’s a simple example:

You borrow J$200,000 at 11 percent add-on interest for 2 years.  Monthly payments are to be made. Total add-on interest = J$200,000 x 11% x 24 / 12 = J$44,000. This figure is added to the principal amount of J$200,000 to get J$244,000. Your monthly repayments would be J$244,000 / 24 = J$10,166.67

Note that add-on interest rates tend to be much lower than regular market interest rates, so consumers could think that the loan is less expensive when it really isn’t. In fact, lending agencies are required to state the effective interest rate when quoting an add-on rate.

Reducing Balance Method

In this repayment method, interest is calculated for each period by multiplying the agreed interest rate by the principal that’s remaining to be paid at that time. The difference between reducing balance and add-on is that interest is not charged on the principal that has already been repaid.

There are two ways of repaying your reducing balance loan: fixed principal payments and fixed total payments. In the first, the original principal is divided into equal monthly payment amounts according to the term of the loan.

The initial interest amount is charged on the original principal and subsequent interest charges are computed on the balance of principal owing. The total repayment reduces over the life of the loan. If you borrowed J$200,000 at 21½ per cent per annum over 24 months, your total repayment amounts would vary from J$11,867.58 per month to J$8,480.59 by the end of the loan.

In the fixed total payment option, a calculation is used to determine how much the total repayment would be, given the interest rate and the term of the loan. The amount that is paid towards the principal would be computed by subtracting the interest amount due each month from the fixed repayment figure. Given the above example, you would pay about J$10,300 every month to pay off the loan.

In coming articles I will look at some pitfalls to avoid when taking out loans.

Copyright © 2007 Cherryl Hanson Simpson. No reproduction without written consent.

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Originally published in The Daily Observer, June 7, 2007

Cherryl is a financial columnist, consultant and coach. See more of her work at www.financiallyfreenetwork.com and www.financiallysmartonline.com. Contact Cherryl