The add-on method is an interest calculation technique used primarily for personal loans, auto loans, and certain fixed deposit products, where the total interest for the entire loan tenure is calculated upfront on the original principal amount and then added to the principal — the resulting sum is then divided equally across all EMI instalments. This differs fundamentally from the reducing balance method (used for home loans and most standard bank loans), where interest is calculated on the outstanding principal balance each month, which decreases as repayments are made. The add-on method results in a significantly higher effective annual interest rate (EAR) compared to the stated add-on rate because the borrower pays interest on the full original principal even as the outstanding balance is progressively reduced through EMIs. For example, an add-on rate of 10% per annum translates to an effective annual rate of approximately 18% to 20% under the reducing balance method. RBI requires financial institutions to disclose the Annual Percentage Rate (APR) to borrowers to ensure transparency in lending costs.
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