When it comes to car finance, we ask ourselves a lot of questions:
- Where can I get the cheapest credit?
- Where can I get credit with a bad credit rating?
- How can I convince a potential lender to provide me with the credit I need?
- Do I need to make a downpayment?
Curiously, very few people ask themselves the one question that’s probably more important than any other:
Can I actually afford a car loan?
It is easy to see why this is so. We all want to be able to keep driving even after our finances have taken a tumble. At the same time, we should be aware of the fact that this is probably not a wise decision.
In this special, we’ll take a look at how you can determine whether you can truly afford to buy a car. We’ll introduce the ability to repay rule and help you decide how much you can afford to spend.
The outcome of these considerations may be painful. But one thing’s for sure: Sliding even deeper into debt is going to be a lot more painful!
Table of Contents
- Looking and buying
- Sometimes it’s best to not buy a car
- Unable to pay: Who’s to blame?
- The ability to repay: A new concept for an old problem
- Check List Part 1: Credit report and credit score
- Check List Part 2: Payment history
- Check List Part 3: Income
- Check List Part 4: Assets / money reserves
- Check List Part 5: Credit utilisation ratio
- An example
- Check List Part 6: Debt to income ratio
- What is a good debt to income ratio?
- How much of your income should you spend on a car?
- Deposit / monthly rates
But … I keep getting offered credit!
When it comes to car credit, the UK’s a strange place. On the one hand, lenders can seem to be obsessed with playing it safe. Good luck talking to them if your credit report isn’t spotless!
Accordingly, many are finding it hard to get any finance at all. We help people everyday with getting a car loan who just couldn’t find one anywhere else.
Then again, dealers will offer credit to just about anyone who comes through their doors. This includes people who have enough financial troubles as it is and really shouldn’t be paying back a loan.
Newspaper The Guardian has reported on cases where financially weak applicants were offered a brand new car without any deposit and extremely low monthly payments. Essentially, these lock the buyer into their contract for years to come. In fact, dealers offering these finance packages are not interested in customers who want to put down some money in advance or pay off their loan quickly.
The paper admits that these practises are not, strictly speaking, illegal. But they do consider them to be problematic.
Looking and buying
As salespeople have noted, sometimes customers will come in just to take a look at the latest cars. They may not even have the intention of buying a vehicle. And yet, when they leave, they have signed a contract for a brand new car.
As one dealer told a journalist disguised as a customer:
“You have the ability to change after three years. You know, like you do with your mobile phone.”
But a car loan is not a mobile phone contract.
For one, you can not switch providers as easily. So even if you could get a better deal elsewhere after the lease expires, it is by no means certain that you will actually be able to take advantage of it.
And then, of course, costs are much higher. If you default on your mobile phone payments, you may end up having to pay back quite a bit of money. But defaulting on a car loan could send you straight into bankruptcy.
Clearly, a different thing!
Which brings us to an important realisation …
… which is: Sometimes it’s best to not buy a car. It may not be what you want to hear. And perhaps you don’t even need to heed this piece of advice in practise. What matters is to take this attitude when going out to look for a suitable used vehicle.
You should always alert yourself to the fact that there is a third option, other than buying an expensive or a cheaper car. And that is, that you can walk away and decide to postpone the purchase until a later date.
This all the more true if you consider that there are types of loans which can get you into trouble really deep and really fast. Payday loans are among the most obvious example for this.
You can get a payday loan very quickly and for quite sizable sums. (Although they usually won’t be enough to cover the full cost of a car.)
The problem is that you also need to pay back these loans very quickly. If you don’t, interest will accumulate at a dizzying pace. Before you know it, debt will have spiralled out of control – dragging you down along with it.
Unable to pay: Who’s to blame?
Here’s a fascinating trivia from the world of car finance: According to a study conducted by credit rating agency Transunion, 30% of participants saw “defaulting on a loan payment as being the fault of the lender rather than the borrower.”
Yes, you read correctly: A third of all consumers believes that if they are unable to pay for a loan, the dealer or bank is to blame.
It seems like a weird distortion of reality.
After all, shouldn’t you be the one who knows best about your finances? And why buy if you know you can’t afford it?
The more you think about this, however, the more it seems to make sense. You may know how much money you currently have. But the ability to repay a loan is not just about the assets on your bank account. It is about a lot of different things and, most of all, their combination.
The lender will know best – from their extensive experience in the field – which combination of factors best determines your ability to repay. They really should know better than to extend easy credit to just anyone who’s willing to sign on the dotted line.
At the same time, you’re still responsible for the consequences of your actions. Don’t expect dealers or banks to bail you out if you encounter problems paying back your loan. And so, it is of utmost importance to verify your ability to pay before you even set foot in a showroom.
Will vs ability
One thing you should be clear about is that, at the end of the day, your ability to pay is determined by money in some form or another.
You may have the best intentions in the world. But if you can no longer keep up your payments, the lender will have desperately little interest in them.
You may really, really, really want to pay more towards your loan each month. Perhaps you have even made the resolution never to miss a single payment. But what good is that if the cash to realise this simply isn’t there?
You may need the car desperately either to apply for a new job or to keep the one you currently have. Without the necessary resources, however, none of that will matter.
If you want to drive a car, you will need to find a solution that takes your financial situation into consideration. Then, you need to follow it through without fail.
The ability to repay: A new concept for an old problem
The term “ability to repay” was coined in the USA. There, it is the gauge by which each loan application is judged. If you apply for a mortgage or a larger credit, such as a car loan, the lender needs to verify you can meet seven criteria. Only if you can check all boxes is the lender allowed to extend credit to you. If you can’t, you’re out, whether the dealer or bank would like to give you the money or not.
This is called the ability to pay rule.
Of course, we have similar approaches in the UK. Each lender has their own set of criteria by which to judge your financial status and creditworthiness. Some of them make more sense than others. But they will ultimately all do the job.
However, we have to be honest: The American approach is to the point and concise and includes just about everything that matters,
Using it as a basis, we have added a few more elements and created the perfect check list for you. Be honest about this! If you’re finding you can not meet most of these demands, it may be best to hold off on that purchase for a little longer.
1. Credit report and credit score
There’s a very good reason for that: Your credit score is the easiest and fastest way for a lender to assess your creditworthiness. With just a single number, it encapsulates your full credit history over the past seven years. In case of doubt, your credit report, which contains a more detailed account, can reveal the background to that number.
But for many financial institutions, your credit score will be enough. Others will run some of your basic data through self-penned algorithms to create their own ratings. Either way, simplicity is key. Which is why your score is pretty important when it comes to your application.
Which is a shame, if you think about it. We’d be the last to deny the usefulness of the credit score. And yet, it never tells the full story. Neither credit score nor credit report contain all the elements required to arrive at a sound evaluation of your financial situation.
As a point of departure, however, it’s pretty good.
2. Payment history
Your payment history can actually tell you a lot about where you typically encounter problems when it comes to paying back your debt:
- It can tell you if a bad credit score is the result of many minor offences or a single major one (like an insolvency). The latter is obviously an issue for lenders. But already the former indicates that you tend to have systematic issues with meeting your obligations.
- It can tell you whether you’ve made progress financially. Let’s say that most of your issues lie in the more distant past. Then your ability to repay would obviously seem to be better than if they’re very recent.
- It will bring into sharper relief whether you mainly struggle with larger single payments or smaller recurring ones. Quite often, the latter are mostly down to forgetfulness on your part. An easy solution is to set up standing orders for your regular commitments.
Using your payment history, write down a few conclusions to work out what is causing your problems. Then, analyse honestly whether you think you can resolve them.
It is quite remarkable that so many lenders don’t even take this into consideration. Yes, it’s true: Your credit report does not contain any information on your income. So any bank or dealer who relies entirely on your score is not considering it for their decision.
That’s pretty bizarre, since your income is one of the most important predictors of your ability to repay.
Even if you’ve had financial difficulties in the past or even if you have quite a bit of debt at the moment, a steady income can make up for these shortcomings. (We should note that you can also have a decent ability to repay even without a steady income. In that case, you would need to have some form of assets. Alternatively, you may be able to use part of your unemployment benefit to pay off a loan.)
Your income alone, of course, is not the only thing that matters. Evaluate how steady this income is (i.e. whether it is the same all the time or fluctuating quite a bit) and how secure (i.e. what the risk of you losing your job is). The more you earn, the steadier your income and the more secure your position, the better obviously your ability to repay.
4. Assets / money reserves
- The money that’s on your bank;
- Any physical items you can quickly sell off to generate cash;
- Immaterial valuables, such as stocks or securities.
For any lender, next to the credit report, your assets are among the most important factors for deciding on whether or not to grant a loan to you. To them, assets are even more important than an income. The simple reason is that assets are completely secure, while your future income is not. If push comes to shove, you may no longer have your job in two month’s time. But you will still have that savings account with a few thousand Pounds on it.
This is something to consider if you’re thinking about taking up a loan. Assets can protect you in case of a financial emergency. It’s certainly better to liquidate that savings account instead of having to file for insolvency.
On the other hand, you need to be sure you are okay with having to sell off precious items. Plus, don’t forget that your assets are supposed to be a safety net. Don’t use it too lightheartedly.
5. Credit utilisation ratio
Most banks will allow you to go into the red with your debit- or credit card. The idea behind these overdrafts is that you don’t have to apply for a credit every single time you buy something slightly more valuable. Imagine getting a new TV and having to enter loan negotiations at your bank, for example. Or for groceries at the end of the month.
There is a limit to overdrafts, of course. If you need more cash beyond this number, you will either have to ask for an extension of your credit line or apply for a real loan.
Let’s say the limit to your credit line stands at £3,000. Although you could technically make full use of this amount, we advise against it. The higher your credit utilisation ratio, the worse your chances of getting a car loan. The reason is that many lenders will interpret this as a sign that you’re facing financial difficulties.
It is generally assumed that a good ratio is below 30%. In our example, that would mean keeping your revolving credit below £9000.
Not only will this improve your chances of getting a car loan. It will also keep your finances more healthy. Debt is eating away at your financial independence and is a constant source of worry and additional costs. The less of it you have, the better.
6. Monthly expenses
This is another underestimated influence on your ability to repay. Even if you have a great job, earn a lot of money, have amassed plenty financial reserves and have never had any financial trouble in the past, you can get into trouble if you spend too much of your hard-earned cash straight away.
Of course, we all need to spend money on food, rent, transportation and the like. And it goes without saying that we all need a little fun as well. Monthly expenses only start turning into a problem once they regularly exceed your income.
You don’t need to gamble or consume drugs to reach this stage. For most people, their income will only just cover their expenses. So whenever an emergency emerges and forces you to go beyond your budget, you will create a negative imbalance.
Saving on non-essentials is one way of dealing with this problem. Trying to improve your earnings another. Whatever you do, keep a close look at your expenses at all time. If they are systematically too high, this will gravely impact your ability to repay.
7. Debt to income ratio
As you can probably tell from the name, the debt to income ratio (DIR) is a very simple relationship. It is extremely easy to calculate, too. And yet it is one of the most revealing numbers to determine your ability to repay.
This is how you arrive at your debt to income ratio:
Start by adding up all your monthly debt payments. Then, divide them by your gross monthly income.
The result will be a percentage. Depending on this percentage, you will either be classified as a risky or a safe lender. The higher the ratio, the higher, in general, will be the likelihood of you defaulting on your car loan. The lower, the higher your perceived ability to repay.
What is a good debt to income ratio?
- “DTI of 0% to 14.9%: You can probably take a do-it-yourself approach to paying down debt. Consider using the debt avalanche or debt snowball method.
- DTI of 15% to 39%: If you have primarily credit card debt, look into a debt management plan from a nonprofit credit counselling agency. You may also want to consider credit card debt consolidation. If you are closer to the higher end of this range, seek a free consultation with a nonprofit credit counsellor and a bankruptcy attorney to understand all of your debt relief options.
- DTI of 40% or more: Look into debt relief options, such as bankruptcy.”
As useful as this overview may be, it is also slightly exaggerated. If you’re looking for a bad credit car loan, a DTI of 40-50% can still be considered acceptable. That’s not to say it is advisable.
No debt at all may be asking too much. But if at all possible, try to gradually reduce your debt below 30%.
How much can you afford to spend?
Up until now, we’ve only talked about how to measure your current financial situation. Using the numbers and ratios we discussed, you should be able to arrive at a pretty accurate picture of your ability to repay. If you’ve been rejected for a credit or if you intend to apply for one soon, these are the wheels you can turn to improve your chances.
Still, the question remains how much you can concretely afford to spend each month.
This is by no means a simple topic. Countless experts have arrived at radically different conclusions. We’ve already tried to shed some light onto the matter in previous blog posts. Here’s a summary of our findings.
Rules, rules, rules
How much of your income should you spend on a car? In a long and detailed article, we discussed this topic at length. Here are some of the most frequently mentioned rules recommended by car finance experts:
- The 36% Rule: This is perhaps the rule of rules. It advises to keep your total loan payments in a month below 36% of your income.
- The 15% rule: A variation of the 36% rule, it recommends not to spend more than 15% of your net income each month on car expenses.
The 10% rule: As above, but replaces 15% with 10%.
- The 15/22/36% rule: Is your head spinning with all these numbers? Here’s yet another rule: Keep the car loan repayment costs to a maximum of 15% of your net income. Keep your total car costs to a maximum of 22% of your net income. And keep your total debt repayment costs below 36%.
- The 20/4/10 rule: Never go for less than a 20% down payment. Never exceed a four year auto loan. And never pay more than 10% of your annual salary on a car.
So which of these rules is best for you? Ultimately, you will need to feel comfortable with whatever rule you pick. So it comes down to personal preferences. If it were up to us, however, a blend of the last two rules seems like a great way to go.
Deposit / monthly rates
- Deposit: This is a somewhat contentious issue. On the one hand, some lenders will refuse to accept anyone unable to make a deposit. On the other hand, some won’t even accept any down payment at all. And to many borrowers, it can seem as though they simply can’t afford any kind of down payment. Certainly, you can take out a loan without any upfront payments. Do bear in mind, though, that a deposit will significantly reduce your overall payments as well as the length of the loan term. If you can afford one, therefore, we highly recommend doing it.
- Monthly rates: Have you ever wondered how you can afford a car credit despite a very bad credit rating? Actually, it’s very simple: By setting a low monthly loan repayment. Although this will make the loan more expensive, it is a sensible way to get behind the wheel again. What’s the point of saving on interest and potentially paying back the loan very quickly, if you end up having to default eventually?
At Concept Car Credit, we focus on your individual ability to repay and then set the monthly rate accordingly, instead of starting with the interest rate. This has helped thousands of satisfied customers. It can help you, too. Give us a call or use our contact form to get in touch – you could be behind the wheel again in no time.