When you apply for a car loan, the lender will review your income, credit rating and debt-to-income ratio to determine if you’re a good fit for financing. The lender wants assurance that you can make timely loan payments each month, and your DTI sheds light on your current debt load and how you manage your finances.
What is Debt to Income Ratio (DTI)?
Your DTI is computed by dividing the sum of your monthly debt payments by your monthly income.
How Debt to Income Ratio Works on Car Loans
There are two types of DTIs to be aware of.
Front-end Ratio
It is commonly used in the mortgage industry and only accounts for monthly housing expenditures (i.e., rent or mortgage payments, property taxes, homeowners insurance and HOA fees).
Back-End Ratio
It considers all your minimum monthly debt payments, with the exception of medical bills that are not in collections, and is the DTI figure auto lenders consider when evaluating your application for an auto loan.
Why Debt to Income Ratio Matters for Car Loans
Your DTI communicates to the lender how much debt payments you have in relation to your monthly income. If this figure is high, you may struggle to repay the auto loan on time, which means lending you the funds to purchase a vehicle could be very risky for the lender.
Consequently, lenders use this figure along with your credit history to decide how much to charge you in interest for an auto loan or if it’s best to deny your application for financing.
How Do You Calculate Your Car Loan’s Debt to Income Ratio?
To calculate the back-end DTI auto lenders use when evaluating auto loan applications, jot down your monthly gross income and add up all of your monthly debt payments. Once you have this figure, divide the sum of debt payments by the sum of your monthly gross income to compute your back-end DTI.
For example, assume you have the following monthly debt obligations:
- Mortgage: $1,500
- Credit card payments: $500
- Student loan payments: $250
You also have two sources of monthly income:
- Full-time job: $5,000
- Freelancing: $1,500
Based on these figures, your back-end DTI would be roughly 35 percent ($2,250/$6,500).
What’s a Good Debt to Income Ratio for Car Loans?
Ideally, you want a DTI below 36 percent to have the best chance of getting approved for a car loan with favorable terms. A higher DTI doesn’t necessarily mean you’ll be denied financing, but you could be offered less favorable terms. A DTI that exceeds 50 percent indicates you could be financially distressed and should seek options for debt relief or find ways to earn additional income.
How Do You Improve Your Debt to Income Ratio?
If your DTI is on the higher end, consider implementing these tips to improve it.
Make Extra Payments
Only paying the minimum on your credit cards will cost you a fortune in interest, and the balances will linger around the same amount for a while. But if you make extra payments each month, you’ll curb interest costs, get out of debt faster and improve your DTI since the minimum payments will start to decrease over time.
Raise Your Income
More income means more cash at your disposal to pay down those pesky debt balances. But be sure to include these funds in your budget and allocate them before they’re deposited into your bank account to ensure they’re used properly.
Control Your Spending
It’s not always necessary to earn more to pay off debt faster. However, there’s a chance you could be overspending on unnecessary items, and scaling back may help you reach your goals faster.
Talk and Negotiate with Your Lenders
If you’ve responsibly managed your debts for some time, some lenders may be willing to offer concessions to make your monthly payments more affordable. However, you’re not likely to have much luck with this approach if it’s for an installment loan with built-in interest and fixed monthly payments.
Don’t Take on New Debts
Avoid applying for any new credit while working towards improving your DTI. Otherwise, you risk racking up even more debt, which also hurts your DTI.
Refinance Your Existing Loans
You could lower your car payment, which in turn lowers your DTI, by refinancing your auto loan. An online platform that specializes in providing a seamless process to consumers looking to get the best deal on auto loan refinancing is ideal.
