Auto Loan APR vs. APY -- What's the Difference?

There is a lot of confusion about the difference between an auto loan APR and an auto loan APY. However, you need a basic understanding of these terms so that you can make an informed decision when you select an auto loan.

APY and APR are two ways of presenting the yearly interest rate for a loan. APR stands for annual percentage rate and APY stands for annual percentage yield.

The key difference between the two is that APY takes into account the effect of compound interest while APR does not. The APR for a loan is calculated by simply adding up the interest rate charged each month. So if the monthly interest rate for a loan is 1%, the APR would be 12%.

The APY, in contrast, takes into account the fact that the amount owed on the loan actually increases every month due to the increase in interest charged. This increase in money owed will then have interest charged on it in the following month.

For example, if you borrow $100 dollars with a 1% interest rate, you pay $1 in interest in the first month. However, in the second month, you $1.01 ($101 x 1%= $1.01). Although the monthly interest rate has not changed, the amount of money owed due to interest increases in the second month because the increase in the first month.

The APR is formulated by adding 1 to each of the monthly interest rates and multiplying the numbers together.  This can be expressed mathematically as (1 + x )^12. In the example above, the APR would be approximately 12.68%.    

Although the difference between APR or APY is accounting distinction, it is very important that you know the difference between APR and APR because they are not the same thing and can lead to different loan costs. As you see from the above example, the difference between APR and APY for a 1% interest rate is over a half percent per year.  As the interest rate increases, this difference becomes even more pronounced.  Confusing the two could mean paying between 1 and 2% more in yearly interest than you anticipate.

Since the APR is lower than the APY, smart lenders will always use APR to make their loans look less expensive. In contrast, smart banks will always use APY to make their interest rates look more attractive to depositors.  As a result, APR is generally used to describe the rate paid to a lending institution by a borrower, while APY generally used to refer to the rate paid to a depositor by a lending institution.

Likewise, since auto loan lender want to make the interest rates for their loans look low, a auto loan APR is the most common way an auto loan is advertised. When you are looking for an auto loan you will want to look for the lowest APR auto loan you can find. However, you should also keep in mind the distinction between APR and APY if for some reason a lender uses APY. The auto loan APR will play an important role in whether you decide to borrow from that lender or not.


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