The Ratio That Can Make or Break Your Car Loan

debt-to-income ratio

A few months ago I applied for a car loan and got promptly roasted by the credit union’s loan underwriter. My credit score is strong, so I wasn’t sure what happened.

“Your debt-to-income ratio is outside of our guidelines,” she told me.

Oh, snap. I think it was her way of politely saying that I earned jack shit, because my only debt is a student loan under income-based repayment and my rent. That’s it.

Just how is the debt-to-income (DTI) ratio calculated anyway?

In simple terms, your debt-to-income ratio(DTI) is the percentage of your income that goes to repay debts such as credit cards, student loans, existing car loan payments, and your rent or mortgage payment. Lending institutions such as banks, credit unions, and finance companies watch this figure closely and it plays a big part in whether or not your application gets approved.

Crunch those numbers

Let’s suppose you rent a room and your rent payment is $600.00 a month. You have a minimum credit card payment of $30.00, along with a student loan payment of $50.00 per month under an income-based repayment plan.

Total debt: $680.00 per month.

Your income before taxes: $1900.00 per month.

$680.00/$1900.00= 36% of your income goes to repayment of existing debt. In most cases, that would put your application in either the “no” queue or the “secondary financing” queue for higher-risk borrowers.

Well, sometimes

Depending on the loan approval guidelines for a given lender, you may still get your loan approved if you have a high credit score, a co-signer, or you’ve been at your current job for a few years. Lenders refer to these factors as “compensating factors” that can offset a less-than-ideal DTI ratio in some cases.

Generally speaking, the lower your DTI ratio and the stronger your credit score, the better chance you have for getting your loan approved by a first-rate lender (trust me. You’ll want a first-rate lender for many reasons).

If your overall debt load is 36% or higher, the lender will view you as a higher risk of default and you may get stuck with a higher interest rate, a larger downpayment requirement, or end up getting financed through some backwoods finance company that will make your life hell.

Fun with numbers

If you want to find out where you’ll really land on the DTI spectrum, factor in your proposed car payment along with your existing installment debt. After all, the lender will do the same thing when determining whether or not you qualify for that low interest rate.

When calculating your DTI ratio, only include installment debt such as student loans, existing car payments, credit card payments. Don’t include utilities or your cell phone bill.

By knowing your DTI ratio in advance, you’ll have a better idea as to how much you can afford to pay without giving a lender (or yourself) a heart attack, and your chances of qualifying for a decent interest rate and quite possibly the car of your dreams.

If your DTI too high, in the 40 percent range for example, it’s best to put off the car purchase until you can lighten your debt load. If you’re screwed and really need a car, prepare yourself for a higher interest rate and/or a limited selection of vehicles, and for dealing with a less-than stellar finance company.

Although your credit score plays a significant role in determining your eligibility for a car loan, your DTI can either help you or hurt you when it comes to getting a good interest rate with a reputable lender and the best shot at getting the vehicle you really want.

Co-signer Or No-signer?

co-signer

Getting turned down for a car loan sucks. In some cases, credit or income issues may be all that stand between you and a new or new-to-you car. A co-signer with a strong credit history and good income may be the answer…or not.

If you’re a first-time buyer with little or no credit or just starting out on the job, chances are it’s tough to qualify for a car loan without a little help. In some cases, the lender or finance company will recommend taking on a co-signer for your car loan.

Your co-signer will sign the paperwork with you, and in turn, they are legally obligated to make the loan payments if you are unable to for any reason. Your BFF may have a great income and excellent credit, but would they be a good co-signer? Probably not.

Taking on a co-signer is a business transaction, so it’s best to leave friends out of it, even if they offer. Same goes for significant others. They mean well, but chances are there will be bad blood if they had to step in and take over your payments if you were unable to.

My neighbor had a rude awakening when his now-ex-girlfriend stopped making payments on the car they co-signed for. My neighbor found out the loan was 45 days in arrears, and the credit union came looking for him to make the payments and to bring the loan current.

Like I said, leave friends and SO’s out of it for everyone’s sake.

Enter mom/dad, grandparents or other relatives. Sure, they face the same risks as do other co-signers, but in most cases, they have the maturity and life experience to view it as a business transaction and treat it as such.

It helps to be on good terms with them in the first place. In that case, parents or other relatives can co-sign for you, and you can refinance the loan into your name only after you’ve made successful payments after a year or two.

family

No-signer

If you and your family are on shaky ground for any reason, don’t do it. It will only strain the relationship even further. Money and family either mix or they don’t. Period.

Don’t do it if your co-signer isn’t fully clear-headed or in good health. Attorneys use the term “being of sound mind and body” for a reason. Grandparents may mean well and want to help, but if their health or mental faculties are fading, they may not fully understand their legal obligation to you and the loan should you lose your ability to pay.

They may also end up experiencing a health-related financial crisis in the near future that will hamper their ability to meet their own obligations, let alone a transaction they co-signed for.

Don’t do it if there are any kinds of strings attached, aside from meeting your obligation to repay the loan. Family dynamics are tricky, so as badly as you may need a car, it may not be worth bringing on a co-signer in the long run if your family relationships are unusually complicated.

Getting turned down for a car loan sucks, especially if you are in dire need of a car. Taking on a co-signer is a major business transaction that requires a clear head and some insight

Next up: How your debt-to-income ratio affects your car-buying chances.