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APR, Annual Percentage Rate explained

APR, Annual Percentage Rate explained

When you’re considering a car loan, one of the main considerations you will have is how much interest you’ll pay. That interest is expressed as APR, Annual Percentage Rate. But what is exactly is it, how is it worked out and why does it vary so much?

APR, interest rate, representative APR, whatever lenders call it, the meaning is the same. The terms all refer to the interest you pay on a car loan. Interest is the ‘cost’ of you borrowing that money added by the lender.

What is APR?

APR stands for Annual Percentage Rate and refers to the total cost of borrowing money over a year.

Different lenders will charge different interest rates depending on the type of loan, your circumstances and your credit score.

The interest is partly made up of the lender’s fee to lend you the money for a car. For most standard car loans, the interest is purely made up of the fee and can be relatively low.

Interest can also be partly made up of a fee to cover any perceived risk of the car loan. For example, a bad credit car loan will have higher interest than a standard one. This is partly a higher fee to cover higher lending costs and partly as these loans are inherently more risky than standard loans.

People are perceived by the industry as being more likely to default on a bad credit loan than a standard one. It’s nothing personal, it’s just how the industry works.

Variable and fixed interest

Most car loans offer fixed interest. The APR is set at the beginning of the loan and stays the same throughout the term. The advantage of fixed interest is that you will always know what you have to pay for the entire loan. The disadvantage is that it won’t drop if interest rates drop.

Variable interest loans are less common for car loans. This is where the interest rate is linked to the wider financial market. It will usually be ‘base interest rate plus x%’.

This can be great if interest rates are low or drop but not so great if interest rates increase.

What is representative APR?

If you go for pre-approval or look online for car loans, you will often see the term ‘representative APR’. The term means the average interest rate that people in your position, borrowing a similar amount will pay. It is not a guarantee of the rate you’ll get.

Like preapproval itself, representative APR takes your situation and loan amount, looks at the market and what the lender is done before and makes a prediction. Those predictions are often very accurate but you won’t know for sure until you actually apply for the loan.

Why does interest vary so much?

Interest varies depending on the type of loan, the amount of the loan, your credit score, the financial market at the time and the lenders own criteria. There is a lot that goes into deciding an interest rate.

A lot of it is down to market forces. How much interest can a lender charge while remaining competitive? The rest comes down to risk, how much you’re borrowing and whether you have ever missed a payment or not.

It’s a complicated market but one that is logical when you can break it down into component parts!

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