The difference between an interest rate and the APR for a car loan
Most car loan agreements list two interest rates: your APR and your interest rate.
Interest rate or note rate is the lower of the two interest rates and represents the annual cost of borrowing, excluding any fees or interest accruing up to the day of your first payment.
APR (or APR) is the higher of the two rates and represents the total cost of financing your vehicle per year (in percent), including fees and interest accrued up to the date of your first payment. APRs are useful for comparing loan offers from different lenders because they reflect the total cost of financing. The higher the APR, the more you will pay over the life of the loan.
From a mathematical point of view, with these tariffs you receive the same monthly payments and pay the same amount for your car in the long term. However, the higher the APR, the more you will pay over the life of the loan. Lenders will provide you with both interest rates in your car loan documents to help you understand your loan.
Distinguishing between these rates is easy in many ways, but it is important that you understand how to interpret each rate.
Interest rate vs. APR
When you buy or finance a car, you may end up borrowing more than your car is worth for a number of reasons (this list is not exhaustive).
- To purchase protection products such as a vehicle maintenance contract, GAP insurance or a tire and wheel protection plan
- To cover the taxes you owe on your purchase
- Pay your prepaid financing costs
The money you borrow to pay for additional products and taxes goes directly into what is known as the “amount financed.” This is the amount you borrow for your purchase. The financed amount essentially reflects how much you would pay for your car even if you bought it with cash (i.e. without financing).
Your prepaid finance charges, on the other hand, are part of your “Finance Fee”. Your financing costs are the costs you pay to compensate the institutions that help you buy your car. Most borrowers understand financing costs as the interest they pay on their loans, and that is correct. However, your financing costs are also made up of fees and/or charges that you pay when purchasing your vehicle. These fees are called prepaid financing fees and are typically included in your financing, so you don’t have to pay them out of pocket. Your prepayment fees may also include interest that accrues up to the day of your first repayment on the car loan.
The difference between APR and your interest rate lies in how you view your prepaid finance charges.
If you prefer to think of your prepaid financing costs as a type of fee you pay to get your loan, then your APR reflects how much you pay in total each year to compensate the institutions that help you finance your car. Both your interest expense and your prepaid finance charges are considered such compensation (i.e. your finance charges), and you will pay these charges in accordance with the repayment of a car loan (repayment refers only to the structured repayment of a debt).
According to the structure of a car loan, you will pay more interest and prepaid financing costs at the start of your loan than at the end. Amortization of prepaid finance charges is discussed in more detail at the end of this document (and you can read more about auto loan interest expense here).
If you would instead like to consider your prepaid finance charges simply as part of your loan, almost as if they were part of the purchase price, then your exchange rate reflects how much you pay to your lender for your loan in addition to your loan principal (i.e. the amount you are borrowing).
The following graphic illustrates the relationship between an APR and a note interest rate.
Example: How to calculate the APR for a car loan
Let’s say you want to buy a car for $15,000. If you use a car loan service, find a lender that will give you a 60-month car loan for that amount at a 6% interest rate (i.e. interest rate). Your loan will have a prepaid finance charge of $200, which means your principal balance will be $15,200 ($15,200 = $15,000 + $200). What would your APR be?
To determine your APR, first determine your monthly payment. If you want to know how car payments are calculated, here is the formula:
Basically, to calculate your car loan payment, all you need to know is the length of your loan in months, your principal amount, and your convertible interest rate (i.e., interest rate). When you plug in the numbers (or use the calculator), you’ll find that your monthly payment on this loan is approximately $293.86.
To find your APR, you could theoretically use the same equation. Your payment based on your grade and APR should be the same. The only thing that changes when calculating APR in this equation is that you would use the financed amount (which does not include prepaid finance charges) instead of your principal. Ultimately, you would plug in your monthly payment and the amount financed and solve for the interest rate part of the equation – which isn’t easy to do mathematically since the interest rate appears twice in the equation.
Still, the APR you would receive if you did this would be around 6.55%. The graphic below shows how the interest rate and APR can get you the same monthly payment and finance fee on your loan.
With these tariffs you receive the same monthly payments and pay the same amount for your car in the long term. However, the higher the APR, the more you will pay over the life of the loan. Lenders will provide you with both interest rates in your car loan documents to help you understand your loan.
Example (continued): An alternative way to calculate the APR for a car loan
Another way to calculate your APR is to think about what your note rate and APR actually reflect.
Your interest rate reflects the interest cost you pay per year on the amount you borrow (i.e. your principal amount), while your APR reflects the portion of your financing costs you pay per year on the amount you finance (i.e. your financed amount). The following equations represent these concepts.
(Note that the “Loan Amount” is the remaining amount of principal and the “Interest Expense” is that paid in a 12 month period.)
(Note that the “Loan Amount” is the remaining balance of the amount financed and the “Interest Cost + Prepayment Fees” are those paid in a 12-month period.)
You cannot use these equations directly to calculate your interest rate and APR because over the life of your loan, your loan amount (i.e., your principal or amount financed) decreases as you pay it off, and as you pay off your loan balance, your interest expense decreases in proportion to the amortization (you can learn how auto loan interest expense works here).
However, you can estimate your interest rate and APR by averaging your loan balance over a 12-month period.
You would pay interest of $838.89 below the APR in your first year and pay interest of $905.02 + prepaid finance charges in your first year below the APR. To calculate an estimate of the note interest rate, you can divide the $838.89 by the average first year loan balance, which is $13,978. You will receive a note interest rate of approximately 6% (6% = $838.89/$13,978).
And if you want to estimate the APR, you can divide the $905.02 by the average remaining balance of the amount financed in the first year, which is $13,888. Your estimated APR is about 6.52% (6.52% = $905.02/$13,978), which is very close to the 6.55% APR in this example.
You can use the procedures described above over any 12-month period of your car loan to calculate an estimate of your interest rate and APR. However, you never have to make these calculations because you can find all the information you need about your car loan in your credit documents. However, we hope these calculations give you better insight into the relationship between your note interest rate and APR.
Amortization of your prepaid financing costs
You pay your prepaid financing costs at the start of your loan, hence the term “prepaid.” Still, your monthly payments are paying off the principal balance of your loan (which likely includes your prepaid fees), so you can think of your prepaid finance charges as another type of interest charge. Because of the way car loan interest works, you’ll pay more interest at the start of your loan than towards the end as your loan balance decreases. This process is called amortization. With the effective annual interest rate, you also pay your prepaid financing costs through the repayment.
In our example, the $200 prepaid finance cost is paid back through amortization, as shown in the graphic below (in orange).
The orange portion of the lines shows the portion of the financing cost for each monthly payment, which is made up of the prepaid financing costs. As you can see, both the blue interest fees and the orange prepaid finance fees decrease over the life of the loan as you pay off your loan balance. When you add up all the interest expense and prepaid finance charges, you will find that the total finance charge is $2,631, making the total payments on this loan $17,631 ($17,631 = $15,000 + $2,631 OR $17,631 = $293.86 x 60 months).
