Debt to Income
The first step in determining how much of a car loan you can afford is to look at your debt to income ratio. In fact, a bank will look at this as well before they offer financing. Your ratio is determined by taking the amount of money necessary to make payment on existing debt each month and dividing it by the amount of your monthly wages or income. For example, if you need $1,000 to pay your mortgage, a student loan and a credit card and you make $3,000 each month, your ratio is 1/3 or approximately 33 percent. The ratio allowed before a bank will not provide you a loan depends on the bank, your credit history and other factors.
Calculating Actual Expenses
On paper in the above scenario, it looks like you have $2,000 each month left over after bills. However, that only includes your recorded debt. You also probably have to pay utilities, phone charges, insurance and other items each month. In addition, you must spend some portion of your income for groceries, clothing and incidentals. In order to determine how much you can afford for a car loan, you need to calculate your actual expenses. Assume you also have $500 in monthly bills from various sources, you spend $200 on groceries, $150 on fuel, $100 on clothing and $100 on entertainment. That is another $1,050 per month, leaving you with $950 after regular expenses.
Leave a Buffer Zone
Here is where many people run into trouble. After the above calculations, they determine they can afford anything up to $950 per month to pay a car loan. Most people will not go into the dealership intending to spend that much, of course. They may set a goal of $350. Once taxes and other things are added, they may end up with a monthly payment of $400. That leaves $550, which may seem like a great buffer. Depending on your situation, that sort of buffer may allow you to save some money, cover unexpected items and have a bit left over. When you decide how big your buffer should be, however, you need to keep the unexpected in mind.
In the end, how much car loan payment you can handle is a personal decision. Taking the time to organize your finances will allow you to gather all the knowledge and data you need to make the right call for your situation.