Determine your borrowing power to see how much you could afford with an auto loan.
Your borrowing power dictates how much money a lender will lend you — and really how much you can afford. If monthly payments from a loan puts too much pressure on your cash flow, that’s an indicator that your borrowing power isn’t as powerful as you think. Before taking out any kind of loan, understand what your personal borrowing power is.
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Why your borrowing power matters for car loans
Understanding your borrowing power can help you save time and limit the number of loans you apply for. Knowing what loans you can afford helps by narrowing the list of lenders, helping you find the best rates for your creditworthiness. Once a lender checks your credit, it’s been recorded, even if you decide not accept the offer. If lenders see multiple inquiries on your credit report, you may be seen as high risk — making it harder to be approved for a loan down the road.
Knowing how much you can afford also makes it easier to shop for the best car for you. You’ll know which makes and models to skip over because they’re out of your price range and which ones are just right for your budget.
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How lenders determine your borrowing power
Lenders consider your monthly living costs and weigh them against your monthly income to see whether you can afford loan payments. However, it gets more involved when you start factoring in:
- Multiple incomes
- Credit card and loan debts
- People who are financially dependent on you
Debt-to-income ratio and how much you can borrow
Another important factor that’s rolled in to how much you can borrow is your debt-to-income ratio. A good rule of thumb is that the debt you pay each month should account for no more than 40% of your monthly income — anything much higher may be seen as a red flag.
When it comes to your vehicle, financial specialists recommend that no more than 20% of your monthly take-home pay should be used towards car expenses.
How to calculate your monthly expenses
You should calculate your monthly expenses before you apply to give yourself a detailed breakdown of your budget. This will help you figure out if you have room for another expense. Look at your personal finances, including:
- Essentials. Think about how much you spend on housing, food, utilities, commuting and other essentials you can’t live without.
- Extras. What do you spend when you go out to eat? Is shopping for clothes twice a month something you can give up? An ideal loan won’t require you to make significant lifestyle changes. If you’re stretching your budget, a loan may not be the right financial move.
- Costs of owning and maintaining a car. These include vehicle registration, licensing, insurance, gas, repair costs and countless others. Leave yourself some financial leeway.
- Debts. Loan payments and credit card bills can add up each month. If they’re not taken care of when the bill is due, you could damage your credit score.
How to increase your borrowing power
There are a few different ways to convince lenders that you’re capable of taking on a bigger loan, however, it may take some time and effort. A few strategies you can use to get a bigger loan in the future are:
- Spend less. Drawing up a budget and sticking with it can free up some cash flow and help you create less debt. And once your start spending less, you can take those savings and knock down whatever debt you’ve accumulated in the past.
- Improve your credit score. Paying bills on time, decreasing your debt-to-income ratio, using your credit card responsibly and correcting mistakes on your credit report can nudge your score in the right direction.
- Eliminate your debt. Cutting your debt minimizes your credit utilization ratio, showing lenders that you’re not desperate for a line of credit.
- Ask for a pay raise. Doing a great job at work and think you deserve a raise? Draw up a case as to why you deserve a pay increase. This extra bump will decrease your debt-to-income ratio and make you appear as a more attractive borrower.
- Compare. Every lender may look at your ability to borrow differently. This is why it’s extremely important to get a few quotes and do your research before moving forward with the first loan offer.
- Get a cosigner. A cosigner promises to take care of the loan if you default, increasing your borrowing power. Only ask someone to be a cosigner if you’re sure you’ll have no problem making the payments on your loan.
Bottom line
Remember to take into account all fees and taxes including the cost of the vehicle when determining how much you can spend on a car. Now that you know what to expect from lenders and what kind of borrowing power you have, you’re ready to compare compare car loans.