by Andrew Rohrlich
What Is APR (Annual Percentage Rate) And How Is It Calculated?
Financing is a significant factor to consider when shopping around for a used car. Most car buyers secure an auto loan. If you've researched auto loans, chances are you've encountered the term "annual percentage rate" or APR. If you are unsure what APR means, this article can help answer some questions you might have.
A loan's APR refers to the amount of money a lender charges a borrower to take out the loan. This amount, determined as an annual percentage, is your total interest plus fees. You can use the following formula to calculate APR:
- Take your monthly payment amounts multiplied by the loan term in months. This figure is your total payment amount.
- Subtract the amount borrowed from the total payment amount. This figure is the total of your interest payments.
- Divide the interest payments by the loan term in months to find the annual interest amount.
- Divide the annual interest amount by the amount borrowed to calculate your APR.
What Are the Primary Factors Included in an APR Calculation?
Because your interest amount plays an important role when you calculate APR from monthly payments, it’s important to understand the factors that can contribute to a higher APR.
Vehicle Age
When you apply for a used car loan, you put your vehicle up for collateral, which means the lender can take possession of the car if you cannot make your monthly payment.
Lenders tend to view older cars as riskier than newer ones since they typically require more maintenance and have a lower resale value.
Depreciation is more challenging to calculate in older cars, and repossession fees are generally higher. A higher annual rate helps protect lenders if they need to take possession of a vehicle they might view as higher-risk.
Vehicle Condition
In addition to the vehicle's age, the vehicle's condition can also drive up your APR. A lender could consider a car high risk if it has issues related to any of the following:
- Major accident damage: Even if a trusted mechanic repaired the vehicle after a collision, it still could be a gamble to finance, as the adverse effects of a significant accident can be long-lasting.
- Neglectful upkeep: Serious consequences can occur if the previous owner failed to keep up with routine maintenance. Services such as oil changes, tune-ups, brake replacements, tire alignments, and more are critical to the condition and lifespan of a vehicle.
- Compromised exterior or interior: Scratched paint, dents, and rust are costly to correct and, in some cases, could lead to bigger issues. A car that has been smoked in or has a damaged interior will cost money to restore.
- Environmental damage: Hail can wreak havoc on the body of a car, including the lights and windows. Water damage is also a significant concern, as it can affect many of the car's components, such as its electrical systems, mechanical parts, and upholstery.
Interest Rate
The interest rate refers to the amount due on top of the principal loan amount. The lender tacks interest onto the borrower's monthly payments and reassesses the annual rate yearly. Factors that impact interest in a used car loan include the risks associated with the collateral and borrower.
Your interest rate has a tremendous influence on your monthly payment. Depending on the size of your loan, just a slight increase in interest can translate to thousands of dollars over the life of the loan. Be sure to read your loan documents carefully, as many people need clarification on their APR and interest rate.
Auto Loan Term Length
The loan term length is a significant factor when you calculate APR on a car loan. If you secure a loan with a longer term, your monthly payments will be less than for a shorter loan. However, your interest payments will be greater over time.
Longer loans are more attractive to lenders because they accrue more money through interest. Some lenders charge a fee if a lender pays off a loan earlier than the loan agreement terms. When comparing loan offers, be sure to read the fine print regarding loan terms.
Principal
The principal is the amount you typically have in mind when you go to a bank for a loan before factoring in any additional costs. For example, if you want a loan for a $10,000 used car, you might ask for $10,000 as the loan amount. When you are approved, this $10,000 is the principal balance.
After fees and interest, your loan amount increases, but the principal amount will stay the same until you start paying it down. To estimate how much you will need to ask as your principal amount, do an internet search for an auto loan calculator to evaluate how much you can realistically afford.
Credit Score
Your credit score is critical in determining your interest and APR. An individual with an excellent credit score is more likely to get a lower APR than someone with a lower score. Credit history is taken into consideration as well. Your credit history tells lenders how likely you are to make your auto loan payments on time.
Similarly, your debt-to-income (DTI) ratio is also very important. Lenders calculate your DTI by comparing your income to your outstanding debt. A loan applicant with a DTI of 45% or less is considered a viable candidate for an auto loan.
For Sale by Owner Car Sales Made Simple
Financing a used vehicle can seem like a lot of work. However, when you take it one step at a time, it can be a deeply fulfilling process. To learn more about how Caramel can partner with you on your used car journey, visit the Caramel website today.
This article was written by Andrew Rohrlich. As a brand and product marketing expert, Andrew Rohrlich has crafted products, experiences and communications for household names like Gap and for multiple automotive technology businesses. For nearly a decade Andrew has studied automotive retail in depth from a customer point of view and aggregated the industry’s best research, thought leadership and know how to provide credible and important information to auto shoppers and sellers.
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