Understanding Your Car Loan APR

Your car loan APR is a measure of the total amount of interest you will pay on your financing, over a one year term. When you receive an interest rate quote from your lender, it may be expressed in interest rate per term. This does not tell you how much interest you will pay per year in annual percentage rate (APR). It also does not show the effect of any compounding interest, which is expressed in annual percentage yield (APY).

The Difference between Interest and APR

Interest is an expression of rate per period. For example, if your lender offers a 2% interest, you should ask if this is interest or APR. If the number is expressed in simple interest, then you can expect to pay 2% on each term for your total length of payment. If you have a 48 month car loan, for example, your APR will be 24% per year for 4 years. This is found using a basic formula:

  • APR = (interest rate per period) * (number of periods in a year)

In the example above, this means:

  • APR = (2%) * (12) = 24%

The Difference between Interest and APY

Annual percentage yield (APY) also takes into account the affect of any compounding interest on a loan. Compounding interest is most common on credit card debt. When you allow a balance to carry over into the next month, the interest compounds, meaning you are paying interest on the interest. Most car loans do not use compounding interest. Consider this example with credit card debt. There is a 1% interest rate on the debt.

  • Paid off immediately within one month the interest equals 1%.
  • The APR on the debt, if not paid off immediately, is 12% per year.
  • The APY is found using the formula APY = (1 + interest rate) ^ number of periods per year -1. Here, the APY would be 12.68%.

It is rare for interest rate on a car loan to compound. This would only occur if you were offered a credit card by the dealer in order to purchase the car. This is not common for car loans; however, it is common for some motorcycle loans. You should be aware of compounding interest whenever you are using revolving credit for a purchase.

What is a Good APR?

A "good" APR is relative for all borrowers. Some borrowers will think 1.7% is an acceptable interest on a car loan because they have very strong credit. Others will not be able to achieve such low interest financing. Others, still, will look for a lower interest such as 1.4%. Ultimately, the goal is to make the cost of financing the car balance the benefits of owning the car. One of these benefits is the growth of an asset. You will own the car out right after the loan is paid, and the value of that asset will negate the cost of the loan. Since car values decrease over time, you will always pay more for a car than it is worth once you own it. This is when factoring in the benefit of owning a car over the length of your loan comes into play.

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