What Is the Difference Between Interest Rate and APR?
Learn what you need to know to make an informed choice and get a better deal on your next auto loan.
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If you're shopping around for a car loan, you might have asked yourself: what is the difference between interest rate and APR (annual percentage rate)? It's a common question — and not just among car buyers.
You may already be familiar with interest rates. For example, your savings account likely pays you interest at a certain annual rate.
The term "annual percentage rate" can be confusing when you first come across it, because it sounds like the same thing as an interest rate. It's important to understand that APR is specific and you'll need to know its impact when comparing auto loan offers.
Here's a look at the difference between an interest rate and APR, and how you can use APR to effectively compare auto loan offers.
Understanding the Interest Rate on an Auto Loan
An auto loan's interest rate is the annual cost to borrow money to buy the car, expressed as a percentage. If you have a good credit score, you may qualify for a low interest rate. If your credit score isn't as good, you might pay a higher interest rate.
However, interest isn't the only cost you could pay when financing a car purchase. You might also pay fees — and that's where APR comes in.
What Is the Difference Between Interest Rate and APR?
APR accounts for both the interest you'll pay and the fees associated with your car loan.
Federal law requires lenders to disclose a loan's APR when a buyer applies and gets approved for financing. You can find this information in large print in your loan contract, which is beneficial to read and understand before signing.
These are examples of fees and add-on products that may impact your APR:
- Document preparation fee: a charge for processing the paperwork associated with your loan
- Credit report fee: a small fee for obtaining your credit history to see if you're a good loan candidate and what rate you're eligible for
- Guaranteed Asset Protection (GAP) insurance: this optional product will cover any shortfall in how much you owe on your loan if your car is totaled
Your lender may include these fees in your loan unless you pay them upfront. Any lender fee you add to the principal you're borrowing can increase your APR.
Some lenders might charge a higher interest rate to avoid charging any fees. If a loan has no fees, then the APR and interest rate will be identical.
How to Use APR to Compare Auto Loan Offers
Understanding APR is part of knowing how much car you can afford. Since APR includes all of the fees associated with your loan and not just the interest rate, it lets you make accurate comparisons between loan offers. In other words, APR can be a better way to compare loan offers from different lenders than simply using the interest rate.
Here's an example: Say you found a suitable car and are weighing financing options. Loan A has an interest rate of 4% and fees of $1,000, which you choose to finance. Loan B has an interest rate of 5% and fees of $250 that you finance. Both loans are for $20,000 and have a 60-month repayment period.
The first loan has a lower rate but higher fees, resulting in an APR of 6%. The second loan has a higher rate, lower fees, and an APR of 5.5%. With the first loan, you'd pay a total of $23,204.82 over five years; with the second, you'd pay $22,928.55. This illustrates that you could end up paying more if you choose your loan based on the interest rate alone.
When you understand the difference between interest rate and APR on a car loan — and why it's important to compare APRs when evaluating loan offers — you can feel empowered to get a better deal. Keep this in mind the next time you borrow money to purchase a car or refinance a loan.
