The annual percentage rate calculated on your car loan is found by taking the rate per period multiplied by the number of payments you will make in a given year. Annual percentage rate is one way to determine the actual expense of financing in a given year, but it is not always the most accurate. You should also consider the effect of compounding interest. You can find this through the annual percentage yield.
When to Use Annual Percentage Yield
Your car lender will often advertise a rate in terms of APR. This means the lender is not showing you the cost of compounding the interest. When you are seeking a new loan or debt, you should always calculate the annual percentage yield in order to determine a more accurate financing cost. Consider the following example.
You have a $5,000 car loan with an interest rate of 2% per month over a 48 month period.
- APR = 12 months (.02 per month) = 2.4% APR
- APY = ( 1 + .02 per month ) multiplied by 12 months -1 = 2.68% APY
This means, when your interest compounds, you are actually paying 2.68% in interest payments each year instead of just 2%. This will greatly increase the total cost of your financing, which can lead you to take too large of a loan. You should always consider APY when you are taking on a new debt to determine the accuracy of the offer a dealer or lender is making to you.
When to Use Annual Percentage Rate
On the other hand, an investment company may offer you a CD or other opportunity based on APY, which includes the effect of compounding interest. This is not altogether a problem, but if you are comparing the offer to another loan that is giving you terms based on APR, you will be comparing apples to oranges. You will need to get both opportunities into the same measurement so you can determine which offer is best. It is often best to get both into terms of APR, which will be the lower quote of the two.
Other Debts that Compound
Car loans and CDs are not the only types of loans and investments that use a compounding interest formula to determine the total amount you will spend in financing. The most challenging example often comes with credit card debt. Credit card debt will not compound if you do not carry a balance from month to month. This means, if you spend $200 at 1% simple interest, you will only owe the $2 finance charge if paid off within the month.
If you carry that balance for a full year, however, you will owe 12% APR on the debt, or $24. Then, if the interest compounds in between months, which it often does, you will actually owe 12.68% interest, or $25.36. Allowing your revolving credit debt to compound month to month will result in much higher payments. In this case, you will spend $23.36 more in interest payments over the course of the year simply by neglecting to pay down the balance after one month.