A car is important for transportation as well as a way to express your personality. According to the Federal Trade Commission, car prices average $28,000 for a new car and $15,000 for a used one, so you likely will need to take out a loan to buy a car. Several factors influence whether you can obtain a car loan and at what interest rate. One of them is the amount of your monthly income.
Your debt-to-income ratio is a major factor in obtaining a car loan. DTI is the amount of monthly recurring debt you have (such as rent, car payment, credit cards or student debt) divided by your monthly gross income before taxes. For example, suppose your monthly income is $4,000, your rent is $1,100, your minimum credit card payments are $30 and your student loan payment is $100. Your DTI ratio, before you buy the car, is about 31 percent.
36 Percent Threshold
Most lenders use a DTI ratio of 36 percent as the threshold for lending. So, in the example above, you'll want to keep your car payment at $200 a month or less. If your DTI exceeds 36 percent, you may still find a lender willing to lend to you, but you'll pay a premium in higher interest rates.
You also want to be sure you can afford to make your monthly payments each month. A good rule of thumb is that your auto expenses (including loan, gas and insurance) shouldn't be more than one-fifth of your disposable income, or what you actually have left after paying rent and other debts. You may be tempted to extend the term of your loan, for example, from four years to six, so that you can buy a more expensive car. If you do this, however, you'll pay a lot more in interest over the longer term. One option is to put some cash down, which will then lower the amount you need to finance, thus lowering your payments.
Income isn't the only factor in whether you'll get a car loan. Credit history, especially your credit score, is another key factor. Checking your credit report before you go shopping or see a lender is a good idea. If your income or credit report are marginal, you may consider asking your parents or another relative to co-sign the loan for you. A co-signer lowers the risk for creditors because he agrees to repay the loan if you don't.
- Bankrate: Auto - How Much Can You Afford?
- Bankrate: Debt-to-income Ratio Important as Credit Score
- The Wall Street Journal: How to Finance an Auto Purchase
- Equifax. "How Credit History Impacts Credit Scores." Accessed Feb. 4, 2020.
- Equifax. "Understanding Hard Inquiries on Your Credit Report." Accessed Feb. 4, 2020.
- FICO. "Amounts Owed." Accessed Feb. 4, 2020.
- Experian. "What Is Debt-to-Income Ratio and How Do I Calculate It?" Accessed Feb. 4, 2020.
Randi Hicks Rowe is a former journalist, public relations professional and executive in a Fortune 500 company, and currently a formation minister in the Episcopal Church. She has been published in Security Management, American Indian Report and Tech Republic.She has a bachelor's in communications, a master of arts in Christian education and a master of business administration.