When you’re buying a car, it doesn’t matter if it’s your first car or an upgrade. There are four things to factor in when calculating how much car you can afford. They are income, DTI, credit score, and down payment amount.

woman in car

Your credit score affects what interest rate you get and will be a key factor when determining car loan approval or denial. The most important factors, however, mostly related to your income, your DTI ratio, and the total down payment amount you can afford (plus some possible hidden elements we’ll get to later).

How do these factors affect how much car you can afford? Get a pencil, some paper, and let’s talk about it.

How much do you have in savings?

Once you have paid your bills and bought essential items, what do you have left over for savings? Is the amount pretty consistent? Lenders won’t look at this number so much, but it’s crucial information for you to know.

Get a number that you’re confident about and write it down. When we start talking about debt-to-income ratio (DTI) and gross monthly income (GMI), you’ll want to see if this number matches up with what lenders think you can afford.

But at the end of the day, it doesn’t matter what other people think. Only you know what you can afford.

What’s your salary?

Ask any financial advisor and most will tell you the same thing: 10% of your take-home pay is the maximum you should spend on a car. Although some say 20%, this number is likely too high for the average borrower with the average amount of monthly debt.

You’re probably thinking that 10% sounds like a low amount, but it’s actually even lower than you think. That 10% needs to include everything associated with the car — meaning you need to factor in:

  • Principal
  • Interest
  • Car Insurance
  • Sales tax
  • Registration fees
  • Documentation fees
  • Routine maintenance (oil changes, tire rotations, alignments, brake pads, etc.)
  • And, most importantly, gas

It’s tempting not to factor in gas, but you need to. Brushing it aside is what leads many people to overuse their credit cards.

What you also need to keep in mind is that both interest and auto insurance vary with the type of car you get (used versus new). If you buy something old with a horrible safety rating, you might pay for it in more ways than one.

How to Calculate Gross Monthly Income

Your GMI is what you make before anything is taken out, such as taxes, insurance, or any other deductions you may have. It’s the most important factor when determining how much car you can afford.

If you are salaried, all you need to do is to take your annual salary and divide it by 12.

If you are paid hourly, you first need to determine how much you make a year. To do this, take the number of hours you work a week and multiply it by how much you make an hour. Then multiply that number by 52 (the number of weeks in a year). Lastly, divide the final number by 12.

Hourly pay x hours per week x 52 ÷ 12 = GMI

If you work a lot of overtime on a routine basis or receive an annual bonus, then yes, those amounts can be used to calculate your gross income per month. Whatever the amount, estimate how much you received the previous year, divide it by 12, and add it to your GMI.

Debt-to-Income (DTI) Ratio

Your debt-to-income ratio is the second most important factor when determining affordability. Even if you make a good amount of money each month, you may not be able to comfortably afford a high monthly payment if you have a lot of debt obligations. For this reason, some borrowers are denied loans even if they have never missed a single monthly payment and have decent credit.

The maximum about of DTI for many lenders is 40%. In some instances, they may allow a loan to push a borrower’s DTI over 40%, but these are exceptions and are by no means the norm.

What debts make up DTI?

To calculate your DTI, you’ll first need to add up all of your monthly debt payments. Notice how we said monthly payments and not total debt. You are only calculating the minimum payment you have to make each month on bills. So the total amount of debt you’re in doesn’t matter; what matters is the total amount of your monthly obligations.

Payments you’ll need to include when calculating DTI are:

  • Credit card payments
  • Student loan payments
  • Mortgage/ rent payments
  • Other car payments
  • Personal loans
  • Second mortgages
  • Child support payments
  • Alimony payments

You do not include the following:

  • Utilities
  • Cell phone payments
  • Cable
  • Internet
  • Groceries
  • Gas
  • Taxes
  • Insurance

How do you calculate DTI?

Add up all of your monthly debts and divide that number by your GMI. The answer will give you your DTI.

Here’s an example.

Say you make a $2,200 per month. You pay $700 a month for rent, about $200 a month for credit card payments, and $120 for student loans. Your monthly debt is, therefore, $1020. Divide that by your take-home pay ($2,200) and your DTI is at 46%, which is too high for many lenders.

If you want to be approved for a car loan in this scenario, you’ll want to first pay down your debts (and maybe find cheaper housing). Without the credit card debt, your DTI would be at 37%. However, even then, your payments would have to be a bare minimum amount so they wouldn’t push your DTI too high.

To better your odds and not strain your bank account, you should probably pay off your debts and look for a more affordable, older car in this case.

Consider a Cosigner

If a bank feels that it’s a good possibility that you will be unable to make your payment (because of credit score, DTI, or income), then getting a cosigner will increase your odds of getting approved for the loan. Still, don’t take out more car than you can comfortably afford, and be positive that you’ll make all payments. If you don’t, both you and your cosigner’s credit will be impacted.

How much should a car down payment be?

Most lenders require borrowers to pay 10% of the purchase price as a down payment. So if you buy a $12,000 car and you plan to finance it with a loan, you’ll need to put at least $1,200 down.

If you buy a new car, you may be required to put as much as 20% down. Some lenders require this amount to offset a new car’s faster depreciation. New cars depreciate 10% the moment you drive off the lot (hence the reason you need to put down an additional 10%).

They’ll then depreciate another 10% after you have owned it for a whole year. So if the purchase price of your new car is $20,000, you’ll need to put down a total of $4,000.

If you have a car you want to trade in, the trade-in value can go towards the down payment. However, it may be in your best interest to sell it privately so you get the maximum amount possible for it.

Another option is to use a cash rebate upon purchase when buying a car. The money you’ll receive doesn’t go to you, but rather to the lender and can be used as part of your down payment.

What if you can’t make the down payment?

Many people use their tax returns to help them make a down payment. If tax season isn’t any time soon, it is possible to get a tax refund loan. You’ll need previous tax returns, pay stubs, and bank statements to provide to the lender, and the lender may decide to give you an ‘advance’ on your tax return.

When your actual tax return comes, it’s deposited directly to the lender as payment. It can be a good option if you need a car but don’t want to throw money at a clunker. Just know that it’s not an even trade and that both fees and interest will be applied. That means that in the end, you won’t get as much money from the loan as you would have if you had waited for your tax return.

Your Credit Score Affects Your Car Payment

A higher score means a lower interest rate and the possibility of not needing a down payment. On the flip side, if you have a high interest rate, your monthly payment is going to be much higher.

A solid income and low DTI are both great to have. But if your score is too low you’ll either pay a higher amount for the ability to take out a loan, or you’ll be denied a loan from the onset.

Car loan lenders break down credit scores into tiers, which is different from the traditional FICO score. Here are the tiers to give you an idea of what to expect:

  • A+ Tier (740-877)
  • A Tier (700-739
  • B Tier (660-699)
  • C Tier (581-659)
  • D Tier (520-580)
  • F Tier (250-520)

Interest rates can vary between lenders and what type of car you intend to buy (used or new). That said, for some lending institutions, the difference between each tier can sometimes vary as much as 4%.

This is why it’s crucial to resolve any errors or negative entries that may be on your credit report before you start shopping. Once you have your credit score where you want it to be, you’ll then want to shop around. Each lender more or less sticks to the above tier system, but the rates for each will vary.

Beware of Hidden Costs

You don’t always get what you see. When shopping, even if you have sorted by monthly payment, many auto dealers are infamous for advertising the price of base models instead of the fully equipped models. That means you’ll see the price of the base model, but the pictures will be of the fully equipped options. To get what you want, you might have to pay $1,000 or more to get it.

Bottom Line

Use a car affordability calculator to determine how much of a loan you can afford. Once you have a ballpark number, you’ll be able to shop around knowing what cars are within reach. Many online auto dealers allow buyers to sort the cars by monthly payment. Use this option to help you shop responsibly.

One last thing to consider: If you have your heart set on a car, but it’s just out of reach, extending the loan term might help enough to make it affordable. Just do your research, imagine where you’ll be in life, and know that in the end, you’ll be paying a lot more than the car’s actual worth (especially when you consider depreciation).