How should I decide how much I can afford to borrow for an auto loan?
Figuring out how much you can afford to borrow before you sign on the dotted line is a great way to stay in control of your finances. It can be very helpful to break the process down into several steps.
1. Assess your financial situation by creating a monthly budget. Here is a budget worksheet and some information on making a budget . You can use this information as you think through how much you can afford to borrow for an automobile. If you’re not sure how to do this, seek help from a non-profit credit counselor .
- First, add up all of your fixed expenses (these include: rent/mortgage, utilities, phone and other recurring monthly bills, amounts you set aside for each month for savings, child support payments, insurance premiums, and payments on any existing loans including outstanding credit card debt).
- Second, add up your estimated additional expenses – for food, gas, entertainment, emergencies and unexpected expenses, and whatever else is not a set monthly expense.
- Third, if you didn’t have a vehicle before, don’t forget you’ll also have to pay for insurance, maintenance, and registration. Shop around for auto insurance before you shop for a vehicle, to get a sense of how that will affect your budget. If you are going from a used vehicle to a new vehicle, your insurance rates may be higher.
- Fourth, if you will be trading in a vehicle but still owe money on it, be sure to find out how much you owe on that loan. If what you owe is more than the trade-in or private sale amount, you will need to account for how you will pay that amount. Your loan amount, monthly payment, and total interest cost will be higher if this old debt is rolled into the loan for your new vehicle.
- Now, subtract all expenses from your take-home pay and any other income you receive on a regular monthly basis.
- Your auto loan payment should be less than the amount you have left.
2. Review your credit.
One of the first things you should do before applying for an auto loan is review your credit report at all of the largest consumer reporting agencies – Equifax, TransUnion, and Experian. You are entitled to a free copy of your credit report from each of these agencies every 12 months, and you can request the free report at www.annualcreditreport.com or by calling (877) 322-8228.
Review your credit report and dispute any errors that you find. A negative error on your credit report could affect the interest rate you get for an auto loan and cost you hundreds or thousands of dollars.
Any negative information on your credit report (such as late payments, delinquencies, court judgments and settlements, or bankruptcy filings) will influence your ability to obtain a loan or to obtain one at a low interest rate.
Most accurate negative information on your credit report must be removed after seven years and bankruptcy information after ten years. If you find a negative item on your report that should have been removed, you should dispute the error on your credit report.
3. Save for a down payment.
It’s important to know how much of a down payment you can afford before you call around for loan quotes or go to a dealer. This will help you decide the size of the loan you can afford. Remember the more you put on a down payment, the less you will need to borrow.
4. Research loan options and consider getting prequalified or preapproved for a loan.
It’s a good idea to shop around for a loan before heading to a dealer. You may want to consider getting prequalified or preapproved for an auto loan from a bank, credit union, or other lender before visiting an auto dealer.
Shopping for the best deal on an auto loan will generally have little to no impact on your credit score(s). The benefit of shopping will far outweigh any impact on your credit. In some cases, applying for multiple loans over a long period of time can lower your credit score(s). Depending on the credit scoring model used, generally any requests or inquiries by these lenders for your credit score(s) that took place within a time span ranging from 14 days to 45 days will only count as a single inquiry.
This means shopping around for an auto loan during that time span will count the same as applying for just one loan. You can minimize any negative impact on your credit score by doing all your rate shopping in a short amount of time.
When you are offered different loans, compare all of the loan terms. You will look at:
- The amount you will borrow;
- The interest rate and the Annual Percentage Rate (APR);
- The length or term of the loan (number of months);
- The monthly payment (and whether you’ll be able to make that payment given your budget)
A higher interest rate or a longer loan term will result in additional interest costs for your loan.
Don’t forget to read the fine print of any loan contract before you sign. Check to see if your loan has a “prepayment penalty,” which means that you will have to pay a penalty if you pay off your loan before the end of the loan term. Even if you’re not planning to pay off your loan before the end of the term, you may want to avoid loans that have a prepayment penalty in case your situation changes. Check the amount you are borrowing to be sure it is the amount you expected. Check that you are getting the amount of credit you agreed on for your trade-in.