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APR Vs. Interest Rate For Car Loans

APR Vs. Interest Rate For Car Loans. An Interest Rate’s Relationship to the Annual Percentage Rate APR for a Car Loan. Your APR and interest rate are typically listed separately in vehicle loan contracts.

The lesser of the two rates, known as the interest rate or note rate, indicates the annual cost of borrowing money and does not include any fees or interest that has accrued up until the day of your first payment.

The annual percentage rate, or APR, is the greater of the two rates and expresses the yearly percentage cost of financing your car, including all fees and interest accrued up until the day of your first payment. Because they reflect the whole cost of financing, APRs are helpful when evaluating loan offers from various lenders. You will pay more over the course of the loan if the APR is greater.

Because of the mathematical relationship between these rates and monthly payments, you will ultimately pay the same amount for your car. You will pay more over the course of the loan, though, the higher the APR. To help you better understand your loan, lenders will include both rates on the paperwork for your auto loan.

Although there are various ways in which these rates differ from one another, it is crucial that you comprehend how to interpret each.

Interest Rate vs. APR

You may borrow more money than your vehicle is worth when you purchase or finance a car for various reasons (this list is not exhaustive).

  • To purchase insurance or protection items like a tire and wheel protection plan, a vehicle service contract, or GAP insurance
  • To pay the taxes you owe on the transaction you made
  • Your prepaid finance charges must be paid.

The money you borrow to cover taxes and add-on items is directly applied to what is referred to as the “amount financed.” It represents the sum you borrowed to fund your purchase. In essence, the amount financed represents the price you would pay for your vehicle even if you paid cash for it (i.e. without financing).

On the other hand, your pre-paid finance charges are included in your “finance charge.” Your finance charge is what you fork over to the organizations that lend you money to buy your car. The majority of borrowers correctly identify finance charges as the interest they pay on their loans. However, the fees and/or charges you pay when you buy your car are also included in your finance charge. Prepaid finance costs are what these fees are known as, and they are typically included in your financing so you don’t have to pay them out of pocket. The interest that has accrued up to the date of your first auto loan payment may also be included in your prepaid costs.

Depending on how you choose to view your prepaid finance charges, APR and your note rate will fluctuate.

Your APR will show how much you pay in total annually to reimburse the organizations who assist you in financing your car if you want to think of your prepaid finance charges as a form of the fee you pay to obtain your loan. You will pay these fees in accordance with the car loan amortization schedule, and both your interest charges and your prepaid finance charges will be considered as such compensation (i.e., your finance charge) (amortization just refers to paying a debt in a structured way).

You will pay more interest and prepayment finance charges near the start of your loan than near its finish, in accordance with how vehicle loans are set up. Near the end of this document, there is a more thorough discussion about the amortization of prepaid finance charges (and you can read more about car loan interest charges here).

Your note rate will show how much you are paying in addition to your loan principal (i.e., the amount you borrow) to your lender for your loan if you like to think of your prepaid finance charges as simply part of your loan, almost as if they are part of the purchase price.

The relationship between an APR and a note rate is shown in the graph below.

APR and a note rate
APR and a note rate

Example: How to Calculate APR for a Car Loan

Let’s say you want to spend $15,000 on an automobile. You locate a lender willing to loan you this much money for 60 months at a 6 percent interest rate through a vehicle loan service (i.e. note rate). Your principle will be $15,200 because your loan includes $200 in prepaid finance charges ($15,200 = $15,000 + $200). Which APR would you have?

Find your monthly payment first, then multiply it by the APR. Here is the equation, in case you’re wondering how auto payments are determined:

How to Calculate APR for a Car Loan
How to Calculate APR for a Car Loan

Basically, you only need to know your loan’s length in months, your principal, and your note rate to figure out your monthly payment (i.e. interest rate). Your monthly payment for this loan will be roughly $293.86 if you enter the figures (or use the calculator).

The same equation could theoretically be used to calculate your APR. Your interest rate and annual percentage rate (APR) should be the same. The amount financed (which does not include prepaid financing charges) would be used in place of your principal for computing APR in this equation. In order to solve for the interest rate component of the equation, you must first enter your monthly payment and the total amount borrowed. This is a difficult mathematical task because the interest rate appears twice in the equation.

The APR you would receive if you did this, however, would be close to 6.55 percent. The graph that follows shows how your monthly payment and finance charge will be the same regardless of the note rate or APR.

same regardless of the note rate or APR
same regardless of the note rate or APR

These rates will result in the same long-term costs for your car as well as the same monthly payments. You will pay more over the course of the loan, though, the higher the APR. To help you better understand your loan, lenders will include both rates on the paperwork for your auto loan.

Example (continued): An Alternative Way to Calculate APR for a Car Loan

Consider what your note rate and APR genuinely reflect as a second method of calculating your APR.

While your APR indicates the fraction of your finance charge you pay a year for the amount you finance, your note rate reflects the annual interest charges you pay for the amount you borrow (i.e., your principal) (i.e. your amount financed). These ideas are illustrated by the equations below – Interest Rate For Car Loans.

An Alternative Way to Calculate APR for a Car Loan
An Alternative Way to Calculate APR for a Car Loan

(Note that the “loan amount” refers to the remaining amount funded, while the “interest charges + prepayment costs” refer to amounts paid over the course of a year.)

Since your loan amount (also known as your principal or amount financed) decreases over the course of your loan as you make payments toward it, and as you reduce your loan balance, your interest payments decrease in accordance with amortization, you can’t really use these equations to calculate your note rate and APR directly (again, you can learn how car loan interest charges work here).

However, using the average of your loan balance over the course of a year, you may calculate your note rate and APR.

Under the note rate, you would pay $838.89 in interest charges during the first year. Under the APR, you would pay $905.02 in interest charges plus pre-paid finance charges. You can divide the $838.89 by the $13,978 average loan debt for the first year to get an estimate of the note rate. You will receive a note rate of approximately 6% [6% = $838.89/$13,978].

Additionally, you can divide the $905.02 by the $13,888 average balance of the amount financed throughout the first year in order to get the APR. You will have an anticipated APR of roughly 6.52 percent [6.52 percent = $905.02/$13,978], which is fairly similar to the 6.55 percent APR in our scenario.

The methods mentioned above can be used to estimate your note rate and APR for any 12-month period of your auto loan. However, since your loan documents will provide you with all the information you require regarding your auto loan, you would never need to use these calculations. But hopefully, these calculations help you understand the connection between your note rate and APR better.

Amortizing Your Prepaid Finance Charges – Interest Rate For Car Loans

The term “prepaid” refers to the fact that you pay your prepaid finance charges at the start of your loan. You can still think of your prepaid financing costs as another kind of interest charge as you repay the principal on your loan (which most likely includes your prepaid charges) with your monthly installments. You pay more interest towards the start of your loan than near the conclusion due to the way vehicle loan interest works; this process is known as amortization. As a result, under APR, you also pay your prepaid finance charges through amortization.

In our case, amortization is used to reduce the $200 in prepaid loan charges. The graph below shows this process (in orange).

Amortizing Your Prepaid Finance Charges
Amortizing Your Prepaid Finance Charges

The part of the finance charge for each monthly payment that is made up of the prepaid finance charges is shown by the orange portion of the lines. As you can see, as you pay off your loan debt over time, both the blue interest costs and the orange prepaid finance charges go down. The overall finance fee, including all interest and prepaid finance charges, comes to $2,631, making the total amount of payments for this loan $17,631 [$17,631 = $15,000 + $2,631 OR $17,631 = $293.86 x 60 months].

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