The interest rate, or Annual Percentage Yield (APY), is one of the most important things to consider when shopping for an auto loan. The sticker price, down payment, dealer incentives and trade-in value for an existing auto are other critical factors for making a purchase. These factors are fairly easy for a consumer to control or be aware of; however, the loan interest rate can add hidden costs to a car purchase.
Definition
The Annual Percentage Yield (APY) for an auto loan is the interest rate applied to the loan that considers not only the balance of the loan but the interest that accrues to the loan each period. The APY may be confused with the Annual Percentage Rate (APR), which is another rate quoted for auto loans, but the APR is simply the basic interest rate charged each month multiplied by 12.
Use
The APY takes into account the effects of compound interest while the APR does not. The APY considers the total amount owed on an auto loan, which increases every month due to the additional interest that has been charged on the unpaid balance. This increase will have interest charged on it in the next month as a result of interest compounding.
Calculation
The APY can be calculated by using the following equation: (1 + r/n)^n - 1, where r = the loan rate and n = the number of compounding periods. This equation is somewhat tricky but can be done easily in a spreadsheet using the POWER function or by using a financial calculator. There are also many automobile buying websites that provide free calculators to do the work. Understanding this equation can enable consumers to compare loan products on an equal basis when one dealer quotes loan interest rates in terms of APY while another uses APR.
Warnings
Due to the inclusion of compounding, the APY is higher than the APR. Some lenders use this factor to make their loan products look less expensive by quoting the APR to customers, rather than the APY. Conversely, banks will use the APY to quote their interest rates, making their checking and savings account products look more attractive to potential depositors. Automobile lenders usually advertise new car loans using APR rather than APY. The most beneficial loan for a consumer would be the lowest APR auto loan. Consequently, understanding the distinction between APY and APR is important for consumers in order to make the most informed decisions.
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