This is a topic that should be understood. I know many people who “buy” a house or a car with having little knowledge on where their money is actually going. When you hear the term “APR” what do you think of? Interest rate? Annual percentage rate? Me too. The only real difference between interest rates and APR is APR is inclusive of fees(lender fees, organization fees). When you hear APR it is misleading if you are not familiar with how they actually work. For an example, lets say you are buying a 30,000 car with a 5 year loan and your APR is 5%. An unfamiliar person may assume “ok so 30,000 X .05= 1,500, thus I will be paying 25 dollars a month towards interest and 1,500 in total interest over 5 years. This may not be a ignorant assumption, but it is completely incorrect. If you are buying a 30,000 car with a 5 year loan and a 5% APR, you will actually be paying around 3,968 in interest over the course of 5 years.
How is this calculated?
This is where it gets a little tricky. Your first months payment will include an interest payment of 125 dollars. To get this amount take (30,000 X .05)/12=125. Your “principle” payment will be 441 dollars making a payment of 566 dollars. You divide by 12 instead of 60 because you are paying the 5% APR every year. You are paying the 5% every year but you are paying it on what is owed; thus as the years progress and you make payments on your car(30,000 originally; 29,558 after 1 month) you will be paying less interest every month(as the 30,000 decreases each month due to your principle payment). Every month your “balance”(how much left you owe on car) decreases your interest payment decreases and your principle payment increases(maintaining the same 566 dollar payment each month). On your next month you will multiply the 5%(.05) with the new balance. The new balance is 29,558; thus (29,558 X .05)/12 =123 dollars towards interest. This calculation will continue for the next 5 years. Each month your principle payment increases and your interest payment decreases. View this picture for a better illustration.
Note the change in principle and interest payment each month. This is a 5% APR 5 year illustration.
How much are you really paying in interest
3,968.22 USD, on a 30,000 loan. Although instinct may tell you to multiply 30,000 by .05(5%), this is an inaccurate way to calculate your true interest payment. Next time you buy a car or a house be sure to use an amortization estimator to get a realistic idea of how much you are paying over time.
Please check out my article on Leasing vs Buying a car. You can navigate to this article by clicking the picture below. Thanks -Andrew