Debt-To-Income Ratio for Car Loans: Key Things To Know
7 MIN READ
Published January 18, 2024 | Updated January 30, 2024
Understanding how car loans work and which factors impact your eligibility can help you determine the steps you can take to get the best possible loan rates. Lenders look at a number of factors to determine whether you’ll be able to repay the loan.
Your debt-to-income ratio (DTI ratio) is one such factor that lenders use to determine how much money you earn each month and how much you spend on debt repayment. While there’s no set debt-to-income ratio for car loans, knowing how it impacts your loan approval is important.
What Is Debt-To-Income Ratio and How Does It Impact Car Loans?
The debt-to-income ratio is expressed in percentages and calculates how much of your gross monthly income goes toward debt payments. When it comes to getting an auto loan, lenders want to ensure you have enough income to cover the new car loan payments in addition to your existing debts.
Front-End DTI Ratio: This ratio calculates the percentage of your gross income that is needed to cover your housing costs, which can be your mortgage with insurance and taxes or rent payments.
Back-End DTI Ratio: This DTI ratio calculates how much of your gross income goes towards non-housing debt, such as credit card bills, student loans, personal loans, and car loans.
While there’s no set debt-to-income ratio for car loans, here’s a look at different ratios and what they might mean:
- 0% to 35%: Manageable debt.
- 36% to 49%: Adequate debt management, but it may be causing you issues in repayment.
- 50% or more: Unmanageable debt. Look into debt relief options or consider credit counseling.
How Is Debt-To-Income Ratio for Car Loans Calculated?
Before you begin shopping for a new car, calculate your DTI ratio to see where you stand. Lenders will consider a few factors into consideration when calculating your debt-to-income ratio for car loans, which we’ve listed below.
Auto loan lenders will consider your gross monthly income for the DTI ratio. Simply divide your annual gross salary and divide it by 12 to get your gross monthly income. If you work freelance, are paid hourly, or don’t work regularly, check your 1099 or W-2 form for the total income and divide it by 12.
Your existing debts include all loan payments, including mortgage payments, credit card payments, student loan payments, child support, and alimony. Do not include monthly expenses, such as utility bills and grocery expenses, in your calculations.
Car Loan Payments
In many cases, the lender will also include your potential new car loan payments in the DTI ratio. The before and after DTI ratios help them determine your eligibility and the amount you qualify for.
Let’s consider an example to understand how the debt-to-income ratio for car loans is calculated. For this example, we’ll be using the back-end DTI ratio.
- Monthly Gross Income: $3,500
- Rent: $500
- Credit Card Payments: $200
- Student Loan Payment: $250
- Potential Car Loan Payment: $350
Your total monthly debt payment for this example is $130. Your DTI ratio is your total monthly debt payment divided by monthly gross income ($1300 divided by $3,500), which is 0.371, or 37.1%.
How Are Interest Rates and Loan Approvals Affected?
When you submit a loan application, the lender will evaluate your DTI ratio and credit score for the car loan. The lower your DTI ratio, the higher the chances of loan approval.
Dealerships, banks, and credit unions will also use the DTI ratio to determine your interest rates. They’ll determine your overall financial health and assess your risk as a borrower. The higher the risk, the more you’ll pay in interest charges.
What Is the Typical Debt-To-Income Ratio for a Car Loan Approval?
Typically, lenders like to see a DTI ratio of no more than 45%-50% after factoring in your estimated car loan payment. This means that after accounting for all your debt payments, potential car payments, and insurance costs, you should have at least half of your gross income available for other monthly bills. Less than 36% is considered to be a good debt-to-income ratio.
Lenders want to ensure that you’ll be able to afford the loan payments, even if you have a high income. Borrowing a car loan when you have a higher DTI is risky because if you don’t have much flexibility in your budget, you may miss payments if an unexpected expense comes up.
How To Improve Your Debt-To-Income Ratio for a Car Loan
If you’re planning to buy a car, there are several things you can do to improve your debt-to-income ratio for a car loan to improve your chances of getting approved.
Reduce Existing Debts
One of the best ways to lower your DTI ratio is by paying down your debts. Make a list of all your current debts and use a debt repayment strategy like debt snowball or debt avalanche to pay them off.
Debt consolidation is another option where you’ll be able to roll multiple debts, such as personal loans and credit card debts, into a single payment to make it easier to pay them off.
“The bottom line is to make sure your debt is low, and your credit is good to get the best interest rate possible,” says Teresa Dodson, a financial expert and the founder of Greenbacks Consulting. “If you need to get a car quickly but have mediocre credit, just make sure to refinance after a year of on-time payments to get a better interest rate,” adds Dodson.
Increase Your Income
Increasing your income is another way to lower your DTI ratio. A higher income will automatically help you lower the ratio even if you don’t pay down your debts. You can also use the extra income to pay off your debts to lower your DTI ratio even more.
Consider starting a side gig, freelancing, or picking up extra hours at your current job to boost your income.
Find a Co-signer
You can also apply for a car loan with a co-signer to improve your chances of getting a loan approval. A co-signer with a higher credit score and lower DTI ratio will lower the risk for the lender. However, it’s important to remember that they’ll also be responsible for repaying the loan if you fail to make payments.
Improve Your DTI Ratio To Get a Better Car Loan Deal
Understanding how the debt-to-income ratio for car loans works, how to calculate it, and how to maintain a healthy ratio can help you get a good car loan deal. If you have a high debt-to-income ratio, there are many things you can do to lower it, as we’ve discussed above.
Your DTI ratio is also an important factor when refinancing your car loan. Whether you’re refinancing or applying for a new loan, we recommend checking your DTI ratio and credit report in advance so you can take steps to improve them before you start the car-buying process. If you have bad credit or high DTI, consider saving up a larger down payment to ease the financial burden.