If you’re planning to buy a new or used car with the aid of an auto loan, there are a few different factors that come into play. While your credit score is definitely one of them, the amount of debt that you owe and the income that you make are others. The bank will combine both of those factors in order to calculate your debt-to-income ratio and determine your creditworthiness. But will that ratio prevent you from getting an auto loan?
What is a debt-to-income ratio?
A debt-to-income ratio (DTI) is your monthly debt divided by your monthly income, Lending Tree reports. Lenders use this information to see if you have enough funds available to afford the car loan’s monthly payments. The DTI is measured in percentages, so the lower the percentage, the better.
For those in challenging credit situations, most lenders are looking for a DTI ratio of no more than 45% to 50%, which includes the proposed monthly payments for the auto loan. The reason for this is that the bank doesn’t want the borrower to go broke, believe it or not.
Calculating your debt-to-income ratio
If you would like to calculate your debt-to-income ratio, then you can take the easy route and use the DTI calculator on Nerd Wallet. But if you would rather calculate it yourself, then there is an easy formula to do so.
- Add up your monthly debt payments: Add up all of your debts every month. This includes your rent/mortgage payment and your credit card bills.
- Find out your gross monthly income: If needed, take a look at your paycheck stubs, W2s, or 1099s in order to figure out how much you get paid every month before taxes.
After you find out the total sum of both your debt and your income, you can then divide the debt amount by the income amount. For example, if your total debt amount is $1,250 every month and your total income is $3,200, then you’ll get a total of 0.39 or 39%.
What is a good DTI?
Lending Tree reports that most lenders want to see a DTI ratio of 36% or less, but it can vary. To break it down for you, here are the tiers of DTI ratios:
- DTI of 0% to 35%: The amount of debt is manageable.
- DTI of 36% to 49%: The debt amount is manageable, but giving you a loan could cause issues.
- DTI above 50%: The debt amount could be managed through some counseling or a debt relief program.
Can your DTI be improved?
Yes. The best ways to improve your DTI would be to pay down your monthly debt, increase your income, or do both. The DTI equation only has two factors, so adjusting one or the other will have an effect on the ratio.
Some lenders will have different requirements when it comes to your DTI ratio. However, a high DTI ratio can mean the difference between getting a car loan and not getting one. So it’s wise to take care of your debts first, if possible, before applying for a car loan.