Understanding Your Debt-to-Income Ratio When Buying a Car

Buying a new car is always an exciting experience. However, before you start browsing dealership lots, it’s important to understand how lenders determine your eligibility for an auto loan One of the most important factors is your debt-to-income (DTI) ratio

As a car buyer, having a solid grasp on your DTI ratio can help set realistic expectations when applying for financing. Read on to learn more about what DTI is, how to calculate yours, and tips for improving it if needed.

What is Debt-to-Income Ratio?

Your debt-to-income ratio compares your monthly debt payments to your monthly gross income. It’s expressed as a percentage and calculated by dividing your total monthly debt by your total monthly income before taxes.

For example, if your total monthly debt payments equal $2,000 and your gross monthly income is $5,000, your DTI would be:

$2,000 / $5,000 = 0.4

0.4 expressed as a percentage is 40%

Therefore, your DTI is 40%

Lenders use your DTI to determine the amount of disposable income you have available to take on a new loan payment, like a car loan. The lower your DTI the less financial risk you pose.

Why DTI Matters for Auto Loans

Along with factors like your credit score and history, DTI is an important criterion lenders use to evaluate your creditworthiness.

Borrowers with lower DTIs are viewed as lower risk because they have more available income to dedicate to a new loan payment after covering existing debts. Those with higher DTIs may struggle to make payments on additional debt.

Each lender has their own DTI requirements, but most look for a ratio of 36% or less. The higher your DTI, the harder it may be to qualify for affordable auto financing.

Improving your DTI before applying for a car loan can help you secure better interest rates and terms. Paying down debts or increasing income are two ways to lower your ratio.

Front-End vs Back-End DTI

There are two main types of DTI ratios – front-end and back-end:

• Front-end DTI focuses only on housing costs like your rent/mortgage payment, property taxes, insurance, and HOA fees.

• Back-end DTI encompasses all monthly debt obligations including housing costs plus credit card payments, auto loans, student loans, child support, and other debts.

Auto lenders primarily consider your back-end DTI when evaluating loan applications. However, some may look at both ratios.

How to Calculate Your DTI for a Car Loan

Figuring out your DTI is straightforward once you have the right financial information:

Step 1) Add up all of your monthly debt payments like rent, existing auto loans, credit cards, student loans, child support, etc. Do not include living expenses like groceries or utilities.

Step 2) Determine your monthly gross income. If salaried, divide your annual pre-tax income by 12. If paid hourly, calculate your hourly wage x average monthly hours.

Step 3) Divide your total monthly debt (Step 1) by your gross monthly income (Step 2).

For example:

• Rent: $1,000

• Car Loan: $250

• Credit Card: $150

• Student Loan: $300

• Total Monthly Debt: $1,700

• Annual Salary: $60,000

• $60,000 / 12 = $5,000 Gross Monthly Income

• $1,700 / $5,000 = 0.34

• 0.34 expressed as a percentage is 34% DTI

Aim to have your DTI as low as possible when applying for an auto loan.

What is Considered a Good DTI for a Car Loan?

As a general guideline:

• DTI below 36% – Excellent. You pose little risk to lenders.

• DTI 36% – 49% – Fair. You may still qualify but with less ideal rates/terms.

• DTI 50% or higher – Poor. May be difficult to get approved.

Again, each lender has their own standards. Do your research to find options that work with higher DTI ratios. Online lenders tend to be more flexible than brick-and-mortar banks.

Tips for Improving Your DTI Before Buying a Car

If your DTI is on the high side, taking steps to lower it can help boost your chances of affordable auto loan approval. Consider these tips:

• Pay down existing debts – Attack high interest credit cards and loans first. Even small balances paid off can help drop your DTI.

• Avoid taking on new debt – Don’t open new credit cards or financing until after you’ve purchased a vehicle. New inquiries will lower your credit score too.

• Increase your income – Ask for a raise, pick up a side gig, or have your spouse/partner work if possible. Added income will help offset debts.

• Make a larger down payment – The more you put down upfront, the lower your monthly car payment will be, minimizing impact on your DTI.

• Extend loan term – Stretching out your repayment term can lower the monthly payment. Just beware of paying more interest over the life of the loan.

• Find a co-signer – Asking a creditworthy co-signer with low DTI to apply alongside you can improve your chances.

With some strategic planning, you can get your DTI in check before hitting the car lots. This will set you up for success when financing your new ride.

How DTI Impacts Interest Rates

Your DTI doesn’t just influence loan approval or denial. It can also impact the interest rate and terms you qualify for.

Borrowers with lower DTIs generally get better rates because they pose less default risk to lenders. Those with higher ratios may only qualify for higher interest subprime loans.

Here are estimates on how DTI can influence auto loan rates:

• DTI below 20% – Prime rates 3-7%

• DTI 21-35% – Near prime rates 7-12%

• DTI over 35% – Subprime rates 12-20%

Rates will vary based on other factors too, like your credit score, down payment, and loan term. But maintaining a low DTI is key to securing the best possible APR.

Other Payment-to-Income Ratios

In addition to DTI, some lenders may look at other “payment-to-income” ratios like:

• Housing payment-to-income ratio (HPTI) – Your monthly housing costs divided by gross monthly income.

• Auto payment-to-income ratio (APTI) – Your estimated new monthly auto payment divided by gross monthly income.

• Total debt payment-to-income ratio (TPTI) – Total of all debt payments including the new auto loan divided by gross monthly income.

These help give lenders a complete picture of how much wiggle room you have in your budget for an additional monthly car payment.

The Impact of DTI on Your Credit Score

It’s important to understand your DTI does not directly affect your credit score. Credit bureaus do not have access to your income or debt payments, only your payment history.

However, high debt loads and high balances reported to bureaus can negatively impact your scores. Maintaining a low DTI helps ensure on-time payments and avoid maxing out limits.

Seeking an Auto Loan With a High DTI

If your DTI is above 50%, it can be challenging to get approved for an auto loan, even subprime financing. Here are some options to consider if you have a high ratio but need a car:

• Apply with subprime lenders – Specialty lenders like Credit Acceptance approve borrowers with credit challenges. Rates are higher but they may work with higher DTIs.

• Try peer-to-peer lending – Sites like Upstart approve applicants based on factors beyond credit and income. More flexible DTI thresholds.

• Bring on a co-signer – Adding a cosigner with better credit and income can improve your chances and lower rates.

• Save up and buy in cash – Avoid financing completely by saving up to pay cash, even if it takes longer. You dictate the timeline.

• Buy from a buy here, pay here dealer – These dealers offer direct in-house financing but charge higher interest rates.

• Improve your DTI first – Paying down debts before applying gives you the best shot at approval.

With persistence and a solid understanding of lenders’ requirements, you can get financed even with less-than-ideal DTI ratios. Test driving and researching financing options is the first step. Don’t get discouraged – there are lenders willing to work with all types of car buyers if you look in the right places.