The car of your dreams may not always be the car for your budget. Calculating how much you can afford on an auto loan prevents you from eying a vehicle that costs more than you can comfortably afford. After all, even if you take out a loan to buy a vehicle, you must repay the money.
Debt-to-Income Ratio
The amount of debt you already have gives lenders insight into how much you can afford to spend on monthly auto payments. They total your current monthly obligations, such as credit card accounts and mortgage loans, and divide the sum by the amount of your monthly income. Ideally, the result should be no greater than 36 percent. Lenders only include credit accounts and child support payments in this equation and exclude things such as utility bills and rent. Based on this equation, the amount of the auto loan you can afford must not cause your debt-to-income ratio to exceed 36 percent. To determine whether this is the case, multiply your monthly income by 0.36 and subtract your current monthly debts from this number. The result is the highest monthly payment you can afford on an auto loan, including interest. Multiply this number by 60 to determine the total amount of the five-year auto loan, with interest, you can afford.
Other Considerations
In addition to your debt-to-income ratio, auto lenders inquire into your credit history to find out whether you repay creditors on time. If not, you may not be able to get a loan or you may get one, but at a high interest rate. Your credit report includes your payment history as well as the number of credit accounts you have and the amount you owe on those accounts. Using this information, credit reporting agencies assign you a credit score between 300 and 850. If yours it at least 700, you're likely to qualify for the lender's lowest interest rates, increasing the amount of the loan you can take out while staying within your price range.
Knowing Your Budget
Since lenders use formulas to determine your ideal price range, their assessment of your finances may not reflect reality. You may have a debt-to-income ratio of 8 percent, for example, but have other expenses that cause you to live paycheck to paycheck. In this case, what the lender says you can afford is actually too expensive for you. Calculate the maximum amount you can afford to spend on auto payments: Subtract your monthly expenses --- including payments to your savings and retirement funds --- from your monthly income. Then, subtract from this amount your typical expenses for items such as groceries and entertainment. What remains is the maximum you can afford on monthly auto loan payments.
Finding an Affordable Vehicle
The surest way to decrease the amount of your auto loan is to decrease the cost of the vehicle you purchase. Used vehicles are less expensive than brand new counterparts, so shop classified ads and used car dealerships. Take the vehicle to a mechanic for an inspection before completing the purchase to ensure you aren't wasting your money. Save for a large down payment to decrease the size of the loan you must take out, which also reduces the amount of interest you must pay. If you save enough to pay entirely in cash you can avoid the need for a loan altogether.
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