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What Is The Difference: Interest Rate Vs APR?

What is the Difference: Interest Rate vs APR?

Why Car Loans May Appear to have Two Rates

Have you ever received a car loan contract and found upon inspection that it lists two interest rates? At first, seeing two rates is bewildering. “How is that possible?” you may wonder, “Did the lender switch rates on me?”

Fortunately, having two rates listed on your car loan paperwork does not indicate that your lender is changing your loan terms. It is actually standard practice.

The two rates on your car loan paperwork are there to make it easier to understand your loan. One of your rates (the lower of your two) is simply your interest rate and the other is your APR, or annual percentage rate. Each rate tells you a different part of the same story. Let’s look at what each rate stands for and how you can compare them.

Couple learning about the difference between interest rates and APRs for car loans

Interest Rate vs APR (and Prepaid Finance Charges)

When you take on a loan, you agree that in exchange for borrowing money that you will compensate your lender for its services. This “compensation” probably brings to mind interest charges, and interest charges are one of the main forms of compensation for lenders. However, interest makes up only part of your “finance charge,” which is the total compensation you pay to your lender and other financial institutions for your loan. You also pay “prepaid finance charges” as a form of compensation. And it is these prepaid charges that are the basis for the distinction between interest rates and APRs.

Your prepaid finance charges, as the name implies, are the fees and charges that you pay to your lender and other institutions before buying your car (or other asset). Usually, you will not pay these charges out-of-pocket so you may not notice them. These charges are almost always bundled into your principal (i.e. the amount you borrow), meaning that you borrow the money for these charges and you pay them back over the course of your loan just like your “amount financed,” or the amount you borrow to make your purchase(s).

Your interest rate and your APR treat your prepaid finance charges differently.

Your Interest Rate is Your Cost of Borrowing Money

Your interest rate is simply the cost of borrowing money, even if some of that money will go towards compensating financial institutions and not directly towards buying your car. So, your interest rate (also known as your “note rate”) treats your prepaid finance charges almost like they are part of the price of your car. Under your interest rate, your prepaid finance charges do not appear to be part of your finance charge.

Your APR is Your Cost to Finance Your Purchase

Your APR, on the other hand, treats your prepaid finance charges as part of your total finance charge, as they are. Your APR reflects the assumption that you will pay down your entire loan, including the amount you borrow for the prepaid charges, with your monthly payments – with each payment including an interest charge.

Your APR will be higher than your interest rate because it reflects the total compensation you will pay on an annual basis to the financial institutions that helped you get your loan. APRs for car loans, mortgages, and other borrowing arrangements are helpful to you because they reveal the total cost of financing your purchase or spending. For this reason, many people believe that APRs are one of the key measuring sticks that consumers should use when comparing loan offers.

EXAMPLE: Interest Rate vs APR

Suppose you want to buy a car that costs $12,000. You do not have the cash to buy this car yourself up front so you decide to use an auto loan service to find a car loan to finance your purchase. You are thrilled to learn that your auto loan service found you a lender that will give you a 48 month loan at a 5% interest rate and with only $200 in prepaid finance charges, making your monthly payments $280.96. But when you get your car loan paperwork you see both the 5% rate and another that says you are financing at a 5.843% rate.

This higher rate is your APR, and it reflects the fact that your loan comes with $200 in prepaid finance charges. So, while you are borrowing $12,200 in total at a 5% interest rate, you are paying about 5.843% per year to compensate your lender for helping you buy your $12,000 car. But both of these rates result in monthly payments of $280.96, meaning your lender did not switch your car loan terms on you. The two rates are there to help you understand how much you are paying for your car and car loan.

You can learn much more about how interest rates compare to APRs here. Or if you just have questions about how car loan interest works in general, visit this page.

At Innovative Funding Service (IFS), we are specialists at all things related to auto finance. When you apply for an auto loan refinance, car lease buyout, or company car purchase, we will walk you through the entire process from finding an auto loan that meets your needs to handling the title transfer on your vehicle. We will assign a dedicated Finance Advisor to you who will walk you through every step of refinancing or financing your car and who will be available to you should you have any questions or concerns.

Would you like to save on your current car loan?

Auto refinancing may help you lower your monthly payments and interest rate. Apply to refinance through IFS today. We offer up to 100% financing for those with credit scores of 525-850.

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