What is APR and How is it Calculated?
You’ve probably heard the term APR tossed around a lot. But what does APR stand for, and what is the difference between interest rate and APR? While these terms are similar, they are not exactly the same.
Today we are talking all about interest rates, APRs, and how they are calculated.
What is the difference between interest rate and APR?
Interest rate and APR are often used interchangeably in the car loan industry, but they are not exactly the same thing. An auto loan’s interest rate is the cost of borrowing money every year, expressed as a percentage. It does not include any fees that are charged for the loan. An auto loan’s APR (Annual Percentage Rate) is the cost of borrowing money every year, expressed as a percentage, including any associated fees.
So while they are similar, they are not exactly the same. The APR is considered to be a more accurate measure of the cost of the loan, as it takes all of the fees into account as well. The Truth in Lending Act requires lenders to disclose all loan terms and fees, so they are obligated to alert you to anything that you are responsible for paying. Since all lenders must disclose the APR, it is a valuable tool for comparing loan terms.
Note: Be sure that you are always comparing APR to APR, not APR to interest rate. You always want to compare apples to apples.
Here’s how to calculate APR on a loan.
A car loan APR is calculated using the interest rate that you are offered. Here are the basic steps to calculate APR on car loans.
- Determine the interest amount
- Add any administrative fees to the interest amount
- Divide by the principal
- Divide by the number of days in the loan term
- Multiply by 365 (one year)
- Multiply by 100 to convert to a percentage
In other words, here is the APR formula:
APR = ((Interest + Fees / Loan amount) / Number of days in loan term)) x 365 x 100
Let’s put this to use. Math class is in session!
For example, say you are borrowing $20,000 to finance your new car. You have a 5% interest rate and a four year loan period. The closing costs on your loan are $700.
Principal (P) : $20,000
Interest Rate (R) : 5%
Time (T) : 4 years
The interest on the loan can be found with the formula:
Total Amount Accrued = Principal (1+Rate x Time)
Total Amount Accrued = 20,000 (1+.05 x 4)
Total Amount Accrued = 20,000 (1.2)
Total Amount Accrued = $24000
So now we know our total amount accrued is $24,000, and our accrued interest $4,000 (Total Amount- Principal Amount). Now we can put all of this in our APR formula.
APR = ((Interest + Fees) / Loan amount) / Number of days in loan term)) x 365 x 100
APR= ((4000 + 700)/20000) / 1460 x 365 x100
APR = 5.875 %
So while your interest rate is 5%, your APR is actually 5.875%. This number more accurately represents the cost of your car loan.
How are car loan interest rates determined?
While the car loan APR is what you should be comparing, this number is based on the interest rate that you are offered. But how are car loan interest rates determined? Why do these rates vary from person to person?
Car loan interest rates are determined by both market factors and personal finance factors.
Market Factors
Car loan interest rates depend in part on how the economy is performing. Interest rates are set by the Federal Open Market Committee (FOMC). If the committee determines that spending needs to be encouraged, it will lower interest rates to do so. We are still in the middle of an unprecedented economic wave following the pandemic, and interest rates are still remarkably low (which is why right now is the perfect time to refinance your car loan). Market rates are expected to increase as the year goes on, so it’s best to refinance your car as soon as possible to take advantage of these low rates.
Your Credit Score and History
Your credit score is the most important factor in your car loan interest rate. Credit scores are the biggest variable from application to application. Your credit score takes into account the following categories:
- Payment History. Do you have a history of on time payments? Have you missed payments in the past? Lenders want to be sure you will pay back your debt on time.
- Amounts Owed. How much money do you owe? The amount of money you owe, your debts, are used to calculate your credit utilization score. A credit utilization score below 30% is considered desirable for lenders.
- Credit History Length. How old are your accounts? Having older accounts and a longer credit history is more favorable to lenders.
- Credit Mix. Do you have a mix of different types of accounts and debts? A good mix might include a mortgage, auto loan, student loan, and credit cards. This indicates to lenders that you can manage your money across multiple accounts.
- New Credit. Do you have a lot of hard inquiries on your credit? Do you have some brand new debts? These might be considered liabilities by lenders.
Your Income
In addition to your credit score, lenders will also look at your income and your debt-to-income ratio. If you are carrying too much debt, the lenders may only offer higher car loan interest rates as they consider you to be a riskier candidate.
The Loan Term
In general, the longer the loan term is, the higher the interest rate you are offered will be. Lenders will offer lower rates for shorter terms. This means that if you select a longer lease period, you are not only paying a higher car loan interest rate, but you are paying it for a longer period of time. This means you will end up paying a lot more money overall by selecting a long repayment period.
How can I get a lower APR car loan?
If you are looking to either secure a new car loan or refinance your car loan you are probably wondering how you can get a lower APR car loan. And the good news is there are some steps you can take to increase your chance of securing a good car loan interest rate.
Step 1. Get Your Credit Report and Review for Errors
Contact one of the major credit bureaus (Equifax, Experian, and TransUnion) to get a free copy of your credit report. You can get your report from each agency for free once per year. Review your report carefully and look for any inconsistencies. Are the dates of opened accounts correct? Are the balances on each account accurate? Is your payment history correct? Make sure that all credit limits are up to date and that all personal information is accurate. If you notice any errors, report them immediately.
Step 2. Request Higher Credit Limits
The higher your credit limits are, the lower your credit utilization ratio will be. This compares the amount of money you owe to the amount of money available to you. Lenders will often increase your limits throughout the years when they review your information, but you can also try requesting a higher limit and see if they will oblige. This will help your score as soon as it is reported to the credit agencies.
Step 3. Keep Your Credit Balances Below 30%
Keeping your balances to less than 30% of your available credit will help your credit score greatly. This will lower the credit utilization ratio we discussed above. The highest credit scores often use less than 7% of their available credit, so keep that in mind when you are looking at your accounts. Working to keep a low credit utilization ratio will help your score immensely.
Step 4. Commit to On Time Payments
Making consistent, full, and on time payments will help your score a lot. Sign up for autopay if you are able to, or set an alert on your calendar if you have a tendency to miss payments.
Step 5. Shop Around and Compare
The car loan interest rates that you are offered will vary greatly from lender to lender, so you really want to prioritize shopping around. If you are looking to refinance, you are in luck – Auto Approve makes shopping around and comparing incredibly easy. We have relationships with lenders all across the country and can easily help you apply to a number of lenders and compare their offers instantly. Think of us as your partner in saving money, because we never mark up our rates. We just pass the savings on to you.
That’s everything you need to know about interest rates, APRs, how they are determined, and how you can get the lowest rates.
Now that you know all about car loan interest rates, you are probably keenly aware that you are overpaying on your loan every month. But you can escape your bad loan terms, and Auto Approve is here to help! Don’t wait any longer to start saving, get your free quote today!