How is a car loan APR calculated?

Car loan interest, also know as the annual percentage rate (APR), is influenced by a number of variables, including the lender, state in which the loan is taken, term of the loan and the principal of the loan.

APR Eligibility

Auto lenders and car companies often use terminology like "for well-qualified buyers" when referring to interest rates in advertising. Qualifying for auto financing is directly tied to the creditworthiness of a buyer. Auto lenders use credit reports and credit scores to determine both creditworthiness and the level of qualification for an interest rate.

Credit scores are determined by a person's history of borrowing, repayment and how much debt they hold. Credit scores range from 300-850, with the higher number being the best possible score. The higher the credit score, the lower the interest rate. Well-qualified buyers are often classified as individuals with a credit score between 720-850.

How the Rate Is Calculated

The rate assigned to the loan is based on above eligibility. The difference between someone with a credit score of 800 and someone with a 700 could be upwards of 1/4 of 1 per cent. While it does not seem like a large figure, 0.25 per cent could represent hundreds of dollars in the end. Interest rates typically step up as the credit score decreases.

Lenders, like banks and auto financing companies, find the best possible interest rate by shopping a buyer's record around once a score is determined. For lenders, it is about making money and how the company can make the most margin (the difference between the loan and actual cost of servicing the loan). While the creditworthiness of the buyer factors in, so does the size of the loan. A £13,000 car and a £26,000 car would have different interest rates attached to them, as the higher loan generates a greater potential of income through interest as well as presenting a greater risk of default, or failure to repay. The term of the loan also affects the calculation of the interest rate. The longer the loan, the more work the lender must perform and the greater risk of default.

For instance: An automaker sells £19,500 car and its lending arm offers a special incentive APR to stimulate sales. Qualified buyers are offered the option of purchasing the car and paying it back over a 36-, 48- or 60-month term. The 36-month term will have the best rate, as it will take less time for the bank to recoup its loan. For this example, it is 2.9 per cent. A 48-month term creates a riskier scenario for the bank and need to make more money. As a result, it will increase its rate 1 per cent to 2 per cent. The same scenario applies to the 60-month loan, which will step up 1 per cent to 2 per cent more.

Payments Calculated

Using the above scenario, let's say that the buyer chooses to pay all of the additional taxes and fees out of pocket and finance the £19,500 car price. This becomes the principal.

Banks use a simple interest calculation to determine repayment. Take the APR and divide it by 12. This represents the monthly interest charge. Lenders assess interest at each invoiced payment to the buyer, which is typically on a monthly basis. The principle is divided by 36 to determine a monthly cost. Then, the monthly principal is added to the monthly interest burden to calculate the monthly payment.

For a buyer seeking a 36-month loan at 2.9 per cent on a £19,500 car, determine the monthly principal payment ($30,000/36 months = £541.6) and add it to the monthly interest charge (2.9/12=.242 per cent per month. £541.6*.00242=$2.01). The monthly payment would by £542.9. The interest paid would be £47.10.

A 60-month term would likely see a special rate of 5.9 per cent. The loan is calculated the same way. Take £19,500 and divide it by 60 months, which equals £277.8. Then, divide 5.9 per cent over 12 months, which equals .00492. Multiply £277.8 by .00492, which is £1.30. The monthly payment drops to £279.1, but the total interest paid is £82.0.

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About the Author

Jared Paventi is the communications director for a disease-related nonprofit in the Northeast. He holds a master's degree from Syracuse University's S.I. Newhouse School of Public Communication and a bachelor's degree from St. Bonaventure University. He also writes a food appreciation blog: Al Dente.

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