As car prices continue to rise, financing your next vehicle may be the only realistic option. After all, who has $25,000 to $40,000 laying around to purchase a vehicle in cash? If you decide to finance a new vehicle, your monthly payment will likely be a few hundred dollars per month, which seems a lot more digestible than parting ways with a pile of cash. But financing comes at a cost, and that cost is the annual percentage rate (APR). What is the APR and how do calculate it on a car loan? We’ll cover that below!
How a car loan works
First, what is a car loan? A car loan is when a financial institution gives a borrower a loan to purchase a vehicle. The financial institution may have strict financing requirements you must meet to be approved for the loan. Additionally, the loan will need to be repaid in full within a specific period of time — typically a few years — and the financial institution will charge interest on the money it lends.
The mechanics of how a car loan works are simple. If one decides to finance a car, the financial institution pays the car dealership the full price of the vehicle. The financial institution will collect money from the borrower each month to pay off the loan. Once the loan is paid off in full, the financial institution transfers the vehicle’s title into the borrower’s name, and it no longer owns the vehicle. If the borrower failed to pay the monthly payment, the financial institution reserves the right to repossess the vehicle.
Why the APR on your car loan is important
The APR on your car loan is important because it affects how much your loan costs per month. When you have a car loan, you must pay back the principal amount, which is the amount the car cost at the dealership, and the interest the financial institution charged the borrower for borrowing the bank’s money. The higher the interest rate is, the more expensive it is to borrow the bank’s money.
Consider the following table:
|Term Length (Months)||60||60|
|Interest Rate %||5.5%||8%|
As shown above, a $35,000 loan with an interest rate of 8% will cost you $41 more per month when compared to a $35,000 loan with an interest rate of 5.5%.
How to calculate the APR on your car loan
Calculating APR is made easy with plenty of online calculators, but it’s important to understand the nuances and mechanics of this equation.
The formula is: APR = [(I/P/T) x 365] x 100
I = The interest rate, fees, and taxes on the loan
P = The principal amount, or the amount of money you borrowed to pay for the car
T = The term of the loan, which for the purpose of the equation is days
Example of calculating the APR on a car loan
An example of this formula in action would look like this.
The total amount of interest, all the fees, and the taxes on the loan have a combined value of $7,500. The borrower borrowed $35,000 for a new car, and it’s a six-year loan, or 2,190 days. The formula would be:
[($7,500 / $35,000 / 2,190) x 365] x 100, which would give you an APR of 3.57%
What is a good APR for a car loan?
The cost of borrowing money is a moving target, but one thing remains constant: the lower the interest rate, the better. A good APR for a car loan is the lowest rate possible.
Factors that will affect the APR on your car loan
Determining what a good APR is for a loan is not as easy as just stating a number. Many factors will affect the APR on your car loan. It’s not an apples-to-apples comparison to compare your APR to someone else’s. Such factors include:
Your credit score
Your credit score measures your creditworthiness in the eyes of a lender. The higher your credit score, the better. If you have a high credit score, a financial institution will consider you less risky and will generally charge a lower cost to borrow their money. If you have a poor credit score, you will be considered financially risky, and a lender will likely charge a higher cost to the borrower for their money to offset the greater risk of giving you a loan.
Lenders are also interested in the overall loan-to-value ratio. This ratio looks at how much you’re borrowing and compares the borrowed amount against the appraised value of the asset, in this case, a car. For example, if you are purchasing a $10,000 car and you put down $2,500, your loan-to-value ratio is 75%, as you are financing the balance of $7,500.
The higher the loan-to-value ratio, the better. Not only would one need to finance less with a higher loan-to-value ratio, it also suggests you’d be less likely to default on the loan considering the investment you already made into purchasing the asset.
The term of the loan is also an important factor that ultimately determines the APR. The longer you borrow money, the higher the APR will be, as the lender will be without its principal balance for a longer period of time. Keeping your loans on the shorter side is a great way to save interest over the duration of your loan.
The federal government
The federal government has many responsibilities, and one of them includes influencing the interest rate on money. If the federal government decides to raise interest rates, banks need to pass that increase on to their borrowers. You can have a great credit score, a strong loan-to-value ratio, and a short loan term, and you may still have a higher APR if the federal government is raising interest rates.
Before You Finance Your Next Vehicle
Before you finance your next vehicle, be sure to compare the APRs of a few lenders. The lower the APR, the less your monthly payment will be. If you’re looking to reduce your monthly payment, work on improving your overall credit score and increasing your loan-to-value ratio. Lenders may be more willing to lend you money at a lower interest rate, which ultimately saves you money each month for the duration of the loan.
What is the formula for calculating an APR?
The formula for calculating APR is: APR = [(I/P/T) x 365] x 100
What is a normal car loan APR?
A normal car loan APR is entirely contingent on the borrower, their credit score, and the overall loan-to-value ratio. New cars also have a lower APR than financing a used car. The current rates hover between 5.15% and 9.5% as of December 2022.
What is a good interest rate for a 72-month car loan?
The lower the number, the better. If you’re financing a new car and have a good credit score, a good interest rate should be around 5.5% to 6%.