There’s no getting away from the fact that interest rates are a pretty dull subject. And as human beings, we’re pretty terrible for blocking out matters that bore us – even if they are beneficial in some way.

But understanding the various types of interest rates seriously pays off when it comes to applying for car finance, so stick with us for a short, yet informative summary, on how the different interest rates compare against each other – and how this can affect the cost of your car loan.

APR

APR stands for Annual Percentage Rate and it refers to the percentage of interest you pack back each year on your loan.

If you borrow a total of £12,000 with an APR of 10%, the interest you pay throughout the first year will equate to £1,200.

However, if after the first year you’ve repaid £3,000 of your loan, the interest you pay will be 10% of the remaining £9,000 you owe. Therefore, the cost of interest you pay back over the second year will be £900. 

Providing you continue to make your monthly repayments, the amount owed at the end of each year will decrease – and the cost of your interest will follow suit.

While APR is the most transparent way of showing you the cost of your loan, there are a couple of things you need to be mindful of.

When APR is advertised, it’s usually presented as a ‘typical’ or ‘representative’ APR, which confirms at least 51% of people who are accepted by the lender will pay this rate. However up to 49% of people who take out a loan may be required to pay a higher APR, e.g. if they have a less than perfect credit score.

It’s worth noting, APR also includes the cost of any additional fees or charges issued by the lender. For example, the interest on the loan itself may be 6%, but the lender may add on an additional 1% arrangement fee, bringing the APR to 7%.

Finally, APRs are subject to change and if this happens it can make matters confusing. And while no-one can foresee when interest rates are likely to increase or decrease, it is worth keeping in mind to ensure you allow for some contingency in your budget.

Flat Rate

Flat rates can be deceiving as they usually have a lower percentage rate than APR. But unlike APR, a flat rate does not change year on year, therefore you pay the interest on the entire loan amount, regardless of how much you’ve repaid.

For example, if you borrowed £12,000 at a flat rate of 6% you would repay £720 in interest each year.

This means that come the fourth year of your agreement, when a considerable amount of your loan has been repaid, you will still be paying £720 in interest (6% of the full loan amount).

Is this a cheaper option? Usually not, and it can be hard to compare the two. But because flat rates can be misleading, all loans issued in the UK are now legally required to be presented with an APR rate, this way you can make a like for like comparison.

Variable Rate

But it’s not all about APR and Flat Rates. Interest rates are influenced by the current market, therefore changes to the economy can cause interest rates to fluctuate with little or no warning.

If you take out a loan with a variable rate, your interest rates are subject to change depending on the condition of the economy. This may work in your favour if interest rates decline, however if interest rates increase, you could suddenly find yourself paying more interest than you bargained for. This is why variable rates are considered a greater risk, and if you don’t have much scope within your budget then this may not be the best option for you.

However, variable interest rates are often lower than fixed rates and if you have a short-term loan agreement, the risk of rates changing throughout the duration of your loan will be fairly low.

Fixed Rate

A fixed rate is the exact opposite of a variable rate meaning your interest rate will stay the same throughout the duration of your finance agreement. This means you’ll know exactly how much you will be repaying throughout the agreement, avoiding all risk and uncertainty.

If you have a tight budget or you’re borrowing money over a longer period of time, fixed rates are generally considered the best option. However, if the market drops and interest rates fall you will not be able to take advantage of the lowered rates - which would be frustrating!