The Ultimate Guide to Buying a Car With Student Loan Debt

There’s no doubt about it – if you’ve graduated with significant student loan debt, that can absolutely complicate your ability to qualify for a car loan. But unless you live in a big city with a good public transportation system, you need a car to get to job interviews and back and forth to work.

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Cash is still king.

If you’re able to pay cash for a car, no worries! Paying in cash means you don’t have to make interest payments on the car at all! It also means you can save a bundle on the sticker price, as private party car sales are almost always at a much lower price than dealer sales, with no additional dealer fees or sales taxes on the transaction. You’ll have to pay title and license fees, or transfer existing tags to the vehicle. Overall, paying cash for the best, safest vehicle you can afford is by far the more economical option

If that’s not realistic, because you don’t have much saved up, and you need a car to earn a living, then you might have to bite the bullet and get a car loan. If you already have significant student loans, credit card debt or other monthly obligations, it’s going to restrict your financing options.

Here’s what you need to know.

Financing is expensive – and bad credit makes it more expensive.

The lower your credit score, the more financing will cost you. According to a recent study by WalletHub, people with fair credit will wind up paying an average of $8,115 in interest payments over the life of a $20,000 five-year car loan – more than four times the $1,916  that an average borrower with good credit would pay over the life of the same loan.

WalletHub also found that credit unions and in-house manufacturer lenders offered the most competitive interest rates, charging 17 percent and 13 percent below the national average, respectively. Regional banks and small community banks were more expensive than the national average.

“Tote-the-note,” “Buy-here-pay-here” dealers, the lenders of last resort, should generally be regarded as just that – a last resort.

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What do lenders want to see?

The most important metric car lenders look at is your DTI, or debt-to-income ratio: Are you bringing in enough cash each month to comfortably cover your car payment and still make your basic housing and other living expenses?

However, DTI becomes much less important if you have good credit, an established credit history with a long track record on old accounts, a large down payment, a quality vehicle serving as collateral, and loads of provable disposable income. If you can meet those criteria, most auto finance professionals will find a way to make it happen.

But for most people – especially younger adults who have student loan debt and are at the beginning of their careers – the debt-to-income ratio is going to be of prime importance.

Note: Student loan payments will count directly against your debt-to-income ratio limit. According to data from the U.S. Federal Reserve, the weighted average student loan payment is over $390 (mean), with a median monthly payment of $222. (median).The greater your payment, the lower the monthly car payment you can qualify for.

Because DTI is such an important factor in auto lenders’ underwriting decisions, every dollar of hard monthly debt service payments in student loans, installment loans or credit card minimum payments directly reduces your ability to qualify for a car loan.

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How DTI is calculated

When you submit a car loan application, lenders will pull a credit report and take a look at your existing and prior credit accounts. They will add up all the monthly payments listed on the credit report, and compare it against your monthly income.

These payments will include:

  • Student loan payments
  • Minimum credit card payments
  • Personal loans
  • Installment loans
  • Other car loans
  • Retail credit loans
  • Rent or mortgage payments

Utilities aren’t normally included in this calculation. Also, lenders are generally much more interested in the monthly payment calculation than in your total outstanding debt.

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Meeting the target.

Ideally, lenders want to see a debt-to-income ratio of 36 percent or lower, though some will let you stretch to 40. That is, if you’re bringing in $4,000 per month, lenders will want to see that all your existing loans, plus their new loan, will not put your monthly payment obligations over $1,440 per month, which is 36 percent of your monthly income.

A few lenders may stretch to 43 percent or even 50 percent of your monthly income in some circumstances. But you have to have something going in your favor to get a lender to bite: Defaults in sub-prime auto loans are rising, which causes lenders to become much more picky about whom they are willing to lend to.

If you have a good credit score some lenders will be more flexible with that 40 percent DTI number and stretch it a little bit. But in general, it’s a good idea to reduce the number of monthly payments – and clear up any outstanding delinquencies – before applying for a car loan.

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Lower your debt utilization ratio.

Are you constantly bumping up against your credit limit? That means you have a high debt utilization ratio, and that’s going to hurt your credit score.

Your debt utilization ratio is the fraction of all your total balances versus your total available credit. This information is “baked in” to your credit rating: It accounts for about 30 percent of your FICO score, according to the Fair, Isaac Corporation. Auto finance managers will also look at it when they pull your credit report.

Example: If you have three open credit cards with a total combined limit of $10,000, and you have balances totaling $3,500, you have a 35 percent debt utilization ratio. Debt utilization ratios of 30 percent or lower are considered reasonable. But a ratio of 10 percent or less is much better and will help boost your FICO score as well.

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What can you qualify for?

Every lender has different underwriting requirements. Some are more conservative than others, and lenders can even become more or less willing to take on riskier loans from month to month, depending on the criteria they’ve promised to their own investors and their own market research. But in general, here is a rough guide to the kind of loan you might expect to be able to qualify for, by credit score.

730+. Super-prime credit. Your debt-to-income will be a minor factor, if you have a solid income history and collateral is there. Terms out to 60 months, which makes it possible to finance larger amounts. You should be able to borrow up to about 30 percent of your monthly income.

640-729. Prime credit. Lenders may be willing to lend up to a 50% DTI cap. You can raise this cap by paying off debt to the point entire payments are eliminated. You can buy more car by increasing your down payment. Terms up to 60 months. Loans up to 20 percent of gross income per month.

590-639. Non-prime credit. The big change here is that 60-month terms may no longer be available. Terms may be capped at 48 months – especially on older or higher-mileage cars. Lenders will typically look for a DTI of 45% or lower.

520-589. Sub-prime. Interest rates climb sharply in this credit tier. Lenders may look for DTIs of 40 percent or less, limit loan terms to 36 months, putting many more desirable cars out of reach because this will increase payments. Borrowers can expect to come up with higher down payments, or get caught in a squeeze between the 36-month limit and the 40 percent DTI cap, which limit options.

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Don’t laugh. He qualified for a better interest rate than you.

520 or less. Deep sub-prime. Lenders may limit loan terms to 24 months, putting many cars out of reach without a very large down payment. Lenders may cap the DTI ratio at 35%, cap the payment amount at 15 percent of gross monthly income, or both.

Co-Signers.

If your credit isn’t so hot, you may be able to get better terms with a co-signer. In many cases, people with bad credit won’t be able to get a car loan at all without one, except at a tote-the-note dealer, where rates are usurious and where they send a repo man out to your home or workplace as soon as you’re two days late with a payment.

But when you ask a co-signer to sign on, it’s a serious commitment for both of you: If you fail to pay the loan off for any reason, the lender can go after the co-signer for the debt. Even if you’re just a little late, it affects your co-signer’s credit score.

If you default on a loan with a family member cosigning, it can be a very uncomfortable Thanksgiving dinner. That goes for student loans, as well as car loans. Both the borrower and the co-signer should be very aware of what they’re signing.

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How to Boost Your Credit Score.

Here are some sure-fire ways to improve your debt-to-income ratio, credit utilization ratio and your FICO credit score over time.

1. Pay off entire accounts.

Zero out your smallest credit card balance – then your second lowest, and so on. Stop spending money on them! Cut up the cards! but don’t close the accounts. Closing existing revolving credit accounts eliminates entire payments from the D side of your DTI calculation, but since you leave the account open, your debt utilization ratio improves alongside your DTI. If you close an account with a zero balance, you effectively increase your debt utilization ratio, not reduce it.

Note that it’s important to pay off entire accounts. This way, you reduce your payments on those accounts to zero. This immediately reduces your debt to income ratio. Making payments on large accounts that don’t reduce monthly obligations in the short term don’t have this effect. Your credit utilization ratio will improve, assuming you don’t close the accounts. But your debt-to-income ratio is a function of payments, not balances.

Note: It’s great to pay off these older accounts. But to maximize your credit score, don’t close older accounts outright. FICO factors the age of your existing credit accounts into account. That would lower the average age of your credit accounts and potentially ding your credit score.

2. Increase your income.

This has an immediate effect on your debt-to-income ratio. All things being equal, an increase in your income also helps you pay down debt, increasing your debt utilization ratio, and raise a down payment. It won’t directly affect your credit score: The bureaus can’t see your income. But money in the bank does help reduce the amount you will need to borrow – and soon puts a lot of quality second-hand, private sale cars within reach, that you may be able to pay for in cash.

3. Apply for a credit limit increase.

This tactic can quickly but modestly increase your FICO score. It won’t affect your debt-to-income ratio, but it immediately improves your credit utilization ratio.

4. Catch up on all delinquent accounts.

One or more serious credit delinquencies can seriously impact your credit score. Your payment history is the single most important factor in calculating your credit score, according to the Fair, Isaac Corporation, which calculates issues the FICO score from credit data reported to it by the credit bureaus. It accounts for a 35 percent weighting.

You can get your own credit report from each of the three major U.S. credit bureaus, Experian, Equifax and TransUnion once a year for free by visiting www.annualcreditreport.com. Go through it, and pay off any delinquent accounts. If there are errors on your report, correct them.

5. Take advantage of Income-Driven Repayment Student Loan Programs.

If you have federal student loans, you may be able to reduce your monthly payment by applying for one of the income-driven repayment options. These reduce monthly payments to a manageable fraction of your current income. Most federal loans are eligible for at least one of the four income-driven repayment plans. This is another way to improve your debt to income ratio fast.

For more information on each of these income-driven repayment plans, and to apply, click here.

It won’t directly affect your credit score. But when the dealer finance manager or auto loan underwriter pull your credit report and calculate your debt-to-income ratio, they’ll see a much smaller monthly outflow.

If they have a hard cap on their allowable debt-to-income ratio, then every dollar that you can eliminate from your monthly student loan payment will mean much more buying power when you get to the car lot.

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Timing.

Additionally, you may want to wait 2-3 months after you’ve paid down some existing debt or paid-up any delinquencies before applying. That gives time for your existing creditors to report your payments to the credit bureaus. It also allows time for the bureaus to update your credit report with the new, improved information.

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