Car Finance: How Much Can You Afford?

A car finance is a major commitment. You are borrowing a large chunk of money and promising to pay for it over several years. You need to make sure that you are in a good position to fulfill your obligations. First, you should be confident enough in the stability of your job and the level of your income for the foreseeable future. Next, you should have built a substantial emergency fund to cover any unforeseen hardship. Finally, you should choose a car that you can afford. Below are some of the ways in which you can determine the amounts you should borrow with car finance:

The Ideal Range

The most straightforward estimate refers to your payment to income ratio. Ideally, this should fall between 15% and 20% of your gross monthly pay. Some even suggest keeping it under 10%. For example, a person who is earning $4,000 a month will be looking at monthly payments between $600 and $800. If they are trying to be financially conservative, then they can take it down further to $400. On the other hand, a person earning $2,000 will need to stay between $300 and $400. It may even be prudent to opt for a used car and pay only $200 a month.

Your Overall Debt

Of course, the monthly car payments are only part of the picture. Every person will be spending for other things such as credit card bills, mortgage, student loans, and personal loans. The overall debt to income ratio should be lower than 35%. If you have a sizeable emergency fund and disposable assets, then you may be willing to get this up to 50%. However, exceeding 50% is already considered by many as a red flag. You should be able to keep at least half of your pay after paying your debts. After all, there are monthly expenses such as utilities, groceries, clothing, entertainment, and so on.

The Down Payment

The down payment is a sign of your current financial capacity to pay for a big ticket item. Although you may be paying for the bulk of the price in installments, you will already demonstrate your financial abilities by settling a substantial portion total. The rule of thumb is to pay at least 20% upfront. This amount may come from your emergency fund but it should not be so large that it empties everything and leaves you defenseless against sudden changes in fortunes. If 20% of the price does this, then you need to look for a cheaper car.