A Sensible Starting Point
The most sensible way to approach this issue is to organize your finances and evaluate your net worth. Your net worth is the amount by which your assets (what you own) exceed your liabilities (what you owe). In simple terms, assets minus liabilities equal net worth.
You can figure out your net worth by listing your assets and liabilities on the Net Worth Calculator. This will give you a clear picture of your financial situation and allow you to plan how much you can spend and where the money will come from.
If you are planning to pay for your car by using money from your savings account or by cashing in some stocks or bonds, use your net worth statement to estimate how much you can comfortably afford.
If, like most people, you're thinking of financing your car through a financial institution or automobile dealership, your net worth statement will be a sound starting point for loan discussions.
Do You Qualify for a Loan
How does a prospective lender determine whether you have the financial ability to handle specific loan? The most widely-accepted guideline for estimating how much of your income can be allocated to monthly loan payments is the Total Debt Service ratio (TDS).
Total Debt Service Ratio (TDS)
The TDS ratio examines the relationship between your total monthly debts (i.e. mortgage payments, property taxes, car loan payments, credit cards, other loans or obligations, etc.) and your gross monthly income. The general rule is that these total monthly payments should not exceed 40% of your income.
The formula for calculating the TDS ratio is:
The Right Debt Ratio for You
If your TDS ratio is close to the 40% maximum, you might want to consider how you will meet all your living expenses before making a commitment. Remember that a debt load amounting to 40% or more of your gross income can quickly translate into 50% or 60% of your after-tax take-home pay. This may not allow enough to cover other important or unexpected expenses.
You may find that you qualify for a car loan based on these guidelines, but you may also decide that a TDS ratio of 40% is just too much to comfortably handle.
Just how much is affordable in your financial situation? One tool that can help you decide is the Net Income Calculator. After you've completed the worksheet, analyze your current monthly expenditures and use this information to establish an appropriate price range for your new car.
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