How to Know If You Can Afford a Car Loan

Taking out a car loan is no trivial matter. It is a financial responsibility that needs to be carefully thought of. If not efficiently managed, it could put a strain on your budget, damage your finances, and even put you deeper into debt. This is why it’s important to know if you can afford a car loan before applying for one.

How Much Can You Afford?

“As little as you can”, says many finance experts. By “little”, it means a maximum 10% of your take-home pay for the car loan payment, a maximum 20% for the total expenses of owning the vehicle, like fuel, insurance, repairs, and maintenance; and a maximum 35% of your pre-tax annual income on the total car loan cost.

Annual Income Benchmarks

• 35% - Considered as the general rule of thumb, spending a maximum 35% of annual income for a car loan helps cover most bases.
• 20% - You can choose to spend only 20% of your annual income for a car loan if you want to buy a new, affordable vehicle or an old, luxury car that’s reliable.
• 10% - If you’re the frugal type who doesn't mind buying a used, older model vehicle just to save money, spending between 10-15 % of your annual income on a vehicle finance is ideal. Old cars have depreciated, making them less expensive. On a side note, they may have problems that require constant repair and maintenance.

The most accurate answer, however, is “it depends”. Your income, lifestyle, and purpose of owning a vehicle will be the biggest considerations that affect your vehicle financing. This is because your life circumstances differ from other people.

For instance, your daily routine may require reliable transportation in the earliest possible time when you still haven’t saved a penny for your desired ride. You can take out a loan to buy a vehicle without providing any down payment. However, this would likely make your loan’s interest rate higher than if you’re providing a substantial down payment.

The rule of thumb, however, is don’t spend more than you can afford. Even if you’re financing your vehicle purchase, make sure that you can make on-time monthly repayments on top of other regular car-owning expenses.

Use Car Loan Calculators

Banks and online lenders install online car loan calculators on their websites to help people who are planning to take out a car loan get an estimate of how much they can afford. Most of these calculators are free to use and user-friendly.

Generally, car loan calculators compute your monthly repayments base on the:

• Amount you want to borrow
• Interest Rate
• Repayment Term

Others include more details like the application fees, type of vehicle, monthly income, and your credit score. The more details the calculators consider in the computation, the better estimate it can provide.

Request for Car Loan Quotes

Aside from using online loan calculators, you can also request for car loan quotes from different lenders. You can either use a “quick quote” online submission form or directly speak with a car financing representative over the phone. This person will do the math for you by asking you questions about the type of financing you need and your desired loan amount and terms.

Unlike online calculators, a car loan representative can provide you with an in-depth explanation of the loan program you desire to get, as well as answer all your questions about vehicle financing. He or she can also consider your unique financial circumstance into the equation and can provide tips to help lower your interest rates and monthly repayments.

Do a Manual Calculation

You can also compute the car loan repayment on your own. First, decide on the car loan amount you would like to spend on your car.

Should it be 35% or just 10% of your annual take-home pay? Be realistic about the length of your monthly repayments. Remember that a long-term loan term will distribute your repayments to many months, making the monthly repayments less. However, you will also have to pay for the loan’s interest for a very long time and your car loan can also get upside-down, which means that you owe more than the car is worth. Meanwhile, a short-term car loan can save you more on interest, but the monthly repayments will be higher.

After deciding on your ideal monthly car payment amount, consider the loan’s interest rate, your desired loan term, your credit score, and your vehicle’s price.

Loan Amortisation Formula

Then, use the loan amortisation formula to know how much each monthly repayment will cost: A=P*(r(1+r)^{n})/((1+r)^{n}-1).A = the monthly payment.

• P = the principal
• r = the interest rate per month, which equals the annual interest rate divided by 12
• n = the total number of months

For instance:

Sample Computation

Do not neglect to check the type of interest being charged. Typically, lenders use the APR or Annual Percentage Rate. The effective Interest Rate considers the compounding effect. At 7% compounded monthly, the APR is 7% while the EIR is a higher 7.22%.

The 20/4/10 Rule

Many car loan experts recommend the 20/4/10 rule in deciding how much you should spend on a car:

• Make a down payment of at least 20%. - If you put less than 20 percent down, you risk becoming underwater on your car loan—meaning you owe more on the car than it’s worth—almost immediately.
• Finance a car for no more than four years. - Four years is the maximum most personal finance experts recommend. If you can swing paying off your car in three years, that’s even better. If you feel you absolutely must stretch your payments further, you could get a five-year loan, but never longer.
• And not let your total monthly vehicle expense, including principal, interest and insurance, exceed 10% of your gross income. - Staying below 10 per cent means you’ll have money to put toward other things—like an emergency fund, a down payment on a house, or a nice vacation.

Use our free Car Loan Calculator to estimate how much you can afford to spend on a car. To get a personalised quote or apply for a car loan, complete the Quick Quote or call 1300 722 210.

See also:

Why Is It Important to Compare Loan Offers?

8 Tricks to Manage Your Car Loan Effectively

Which is the Best Bank for a Car Loan? (Part 1)