Auto loans are similar to home loans in several ways, especially when it comes to the application process. While auto lenders that arrange financing may be willing to accept worse credit than mortgage lenders, it will still closely examine the borrower's financial status. A key part of the application process is the debt-to-income ratio, which shows the lender the borrower's potential for repayment.
Debt to Income
The debt-to-income ratio shows all the money the borrower owes per month, compared to the income the borrower makes per month. On the debt side, the lender places all the debt expenses that the borrower has averaged out per month: costs like taxes and insurance are typical considerations as well. The lender then adds all the debt payments for other loans, like mortgages, that the debtor must make. On the income side, the lender places all funds received from jobs and investments. The amount of debt is typically expressed as a percentage of the income.
Ideally, borrowers will have a low debt-to-income ratio, which shows that a large amount of income is free to pay future debts—in other words, a new auto loan. Auto lenders like to see a total debt-to-income ratio of around 30 to 40 percent. Anything above 50 percent will usually result in a very unfavorable loan or a rejection. Anything below 36 percent is often seen as positive.
There are many variables that control what debt-to-income ratio auto lenders like to see. The market itself plays an important part. If the economy is in recession and many debts are being defaulted on, the lenders will try to decrease their risk and may require a debt-to-income ratio of 20 percent or less. The stronger an economy is, the more likely this limit will rise. The credit history of the borrower will also play an important part in the application process.
Borrowers that have a higher ratio than they would like for an auto loan should try to lower the debt side of their ratio, however possible. Some expenses, especially those associated with taxes and houses, are more or less permanent and difficult to change. However, borrowers can improve their ratios by paying off temporary debts, especially credit card debts and other short-term loans or lines of credit.