Calculating how much you can afford

Can you afford to purchase a new car? If you can afford to purchase a new car what can you afford to purchase? To determine the answer to these questions we need to consider three personal details. What can you afford to pay per month, what is your FICO score and how much interest do you expect to pay on your purchase?

To get the answers to these questions lets consider the options available to use if we are thinking of purchasing a new car and have less than perfect credit. The first step is to assess your personal budget and determine what you can afford a month. There are many guides to personal budgeting available to you but I find they often do not accurately reflect how much spare money you have each month. Ideally you would want to track every cent that you spend for at least a month in order to determine what you really spend your money on and how much you can afford. You might be surprised to learn exactly where your money is going each month. Lets assume that after carefully considering your current financial situation you can afford to pay $250 a month for a new car and that you expect your job to be stable for at least 5 years.

Now comes the tough and embarrassing part, determining your credit worthiness. The amount of interest you can expect to pay based upon your FICO score will vary from one area to another. To be sure you must check the government web sites in your area. Keep in mind that many financiers of loans will add a few percent to the base rate so the numbers you find are not written in stone. On average you can expect to pay the following base interest rates for a new car:

  • FICO 690-850 = 6%
  • FICO 625-689 = 9%
  • FICO 590-624 = 14%
  • FICO 500-589 = 15.5%

Now that you know about what to expect to pay in interest rates, and you know how much you can afford to pay per month you can calculate how much you can borrow for a new car. The formula for doing so is:

A=P/I [1-(1+I)^-N]

Where A is the amount that you can borrow based upon the amount a month that you can afford to pay (P), the amount of interest you expect to pay (I) and the length of the loan in months (N). Since the interest rate is based upon a yearly rate you must divide the number by 12 before doing the math. To see how this works lets consider our example of being able to afford $250 for 5 years with a FICO score of 603 thus meaning about 14% interest.

A= 250(monthly payment)/0.01167(14% interest or 0.14 divided by 12) multiplied by [1-(1+0.011167 (interest rate divided by 12) to the power of -60 (months))]

When we crunch the numbers is looks like this:

  • A = 250/0.01167 [1-(1+0.011167)^-60]
  • A = 21422.45 [1- (1.011167)^-60]
  • A = 21422.45 [1- 0.5136]
  • A = 10,419.88

By our math we can see that the cost of our new car after taxes and warranty can not exceed $10,419.88 if we wish to work with our current budget. Doing the math like this can be a little bit of work but there are many online calculators that will do it for you.

The value in taking the time to do this math is to determine if now really is the time to be shopping for a new car. Perhaps it would be in your best interest to wait a little longer and work on improving your FICO score before seeking a loan. As you have seen a few percent could mean a big break in interest rates and thus allow you to get a better car or terms for your loan. On the other hand taking the time to do the research and math before shopping will give you a much better idea of what you can expect to pay for your new vehicle before shopping. Either way it is always in your best interest to look at your current situation and do the math to determine if the option you are considering is the best option for you.