Determining the size of a car loan that you can afford is never a simple thing. Generally, you can, at maximum, borrow an amount that equal to 6-10 times your gross monthly income. At the same time, most financial experts recommend allocating no more than 8-10% of your gross monthly income toward your monthly payment. And finally, it is best to keep your financing term as short as possible. Auto loans of 72 months and longer have become popular because they keep your payments low while allowing you to borrow a greater amount, but they result in greater total interest, as well as a heightened risk of negative equity.
Minimum Criteria and Ground Rules
Even when you have determined how much you can afford, lenders may have a completely different idea based on your credit and income.
A potential lender will consider your after tax income, current debt repayment load, and credit score when deciding how much money they will allow you to borrow. The formula used is slightly different depending on which lender you choose, but there are some generalities. You will need to have a monthly after tax income of at least $1250. You cannot owe more than 30 percent of your after tax income for debt repayment. Lastly, the worse your credit history is, the less you will be allowed to borrow, especially if you have had a vehicle repossessed in the past.
The Impact of Credit on “Income Factor”
Typically, if you have excellent, top-tier credit, you can borrow up to 10 times your gross monthly income. If you have very bad credit, you can only borrow 6 times your monthly income. Most consumers have a score that puts them somewhere between these two extremes, enabling them to borrow somewhere between 7-9 times their monthly income. In the industry, the multiple used to determine this amount is known as an “income factor.”
Please note, it is seldom a good idea to max out how much you can borrow. A vehicle is a depreciating asset, so it is better not to overextend yourself in paying for it. Some finance bloggers and professionals have even taken a hard line on this subject, stressing that you should only allocate 10-30% of your annual income on a vehicle, which would equate to an income factor of just 2-4. Borrowing less allows you to pay back the loan in a shorter time, minimizing how much you pay in interest and minimizing the amount of time you will be “under water” on the loan.