Understanding the difference between APR and interest rate

When you’re getting ready to purchase a vehicle, arranging financing in advance can save you a lot of hassle. But auto loans come with some technical jargon that could easily leave any car buyer befuddled. The difference between the Annual Percentage Rate (APR) and interest rate is one such common confusion. Signing on the dotted line without understanding these could drag you into financial trouble when it’s time for repayment.

Understanding interest rate vs APR car loan calculations

So, is APR the same as the interest rate on a car loan? This is a common question when shopping for auto financing solutions. They are, in fact, two distinct rates that refer to different aspects of a loan’s financing cost. Understanding these terms can help you determine how appealing an auto loan product is.

The interest rate is the percentage charged on what you borrow from a lender. It's a simple percentage that represents how much you'll pay in interest. The APR, or the annual percentage rate, considers the interest rate as well as other borrowing fees such as prepaid finance charges. The higher the additional fees, the higher the APR would be, despite the interest rate remaining unchanged. So, the APR will provide a much more accurate picture of the cost of financing a vehicle and your final repayment responsibilities.

Now, let’s illustrate this with an example. When you’re borrowing $10,000 at a 6% interest rate over 60 months, then the monthly loan repayment amount may seem straightforward. However, extra fees related to the loan drive up the total cost of borrowing.  So, for example, if there’s a loan processing fee of $200, then your actual cost of borrowing will be higher than what the interest rate indicates. The APR reflects this by accounting for extra charges related to the loan.

Why is the difference between APR and interest rate important?

Knowing the difference between APR and interest rate can prevent you from comparing APRs with interest rates when assessing auto financing options offered by different lenders. Understanding these financial terms lets you compare apples to apples and will give you confidence in your financing decisions.

You should always check with your lender about the APR of its auto loan and go into detail about its composition. The federal Truth in Lending Act (TILA) has made it necessary for lenders to disclose this information to their borrowers. This has helped ensure greater transparency so borrowers can make a better-informed decision, avoid misunderstandings, and paying too much for financing or taking up financing they cannot afford in the long term.

Can interest rate and APR be the same?

The interest rate is lower than the APR when additional loan related fees are involved. But can the APR be the same as the nominal interest rate? The simple answer is that it’s certainly possible.  For example, the two rates will be the same when there are no additional financing charges.

Is it better to have a lower interest rate or APR?

A lower interest rate doesn’t always guarantee a lower borrowing cost. This is because additional fees could significantly raise the APR.  The lowest possible APR is always the best option since it indicates the overall cost of borrowing.

However, comparing auto financing options offered by two or more lenders is not that straightforward. You should also consider other loan terms. For example, the repayment period will affect the total cost of borrowing. You will end up paying more in interest for a 60-month loan compared to a 48-month option, even when the APR and principal amount remain the same.

When comparing the APR of different financing options, you must compare on similar grounds where all other terms remain the same.  This will give you an accurate idea about the borrowing costs and repayment amounts. You should also evaluate the various extra fees that go into the APR calculation of each lender. It could be particularly helpful when it comes to finding better rates.

Getting ready to apply for financing

Understanding the various factors that affect the interest rate and the APR of financing is also important as you prepare to apply for an auto loan. For example, your credit score could play a key role when determining the interest rate. And the interest is often higher for used vehicles compared to newer ones. It could also increase with the repayment period.

It’s equally important to accurately assess the amount you need to borrow. Knowing this number can help you calculate a monthly repayment amount you can afford.  If maintaining a low monthly repayment amount is important to you, you can consider a longer loan period, although it may increase the overall cost of borrowing. All these details could help you make a prudent financial assessment before purchasing your new vehicle.