It is always a good idea to pay down your debt. Surely, you have heard that mantra before. It is shouted from every personal finance rooftop on the internet. But why is it such a good idea, especially when you look at it in the light applying for a new car loan? There are many reasons you might not be immediately aware of, so here we go.
FICO Auto-Enhanced Score
When you apply for a car loan, any lender that you apply through will pull your FICO auto-enhanced credit score. This score looks at the five traditional categories that are used to build a credit score:
- Payment history (35 percent)
- Amounts owed (30 percent)
- Length of credit history (15 percent)
- Types of credit used (10 percent)
- New credit/recent credit lines (10 percent)
The auto-enhanced score takes a specific look at your past use of car loans and adds/subtracts points based on your repayment of those loans. This score is different than the basic score that you can buy from FICO and is only available to lenders. This score directly affects loan approval, the interest rate offered, and the length of the loan term.
Loan-to-Value Ratio (LTV)
The loan-to-value ratio of a vehicle is a critical factor in determining whether a loan will be approved or not. This is the value of the car compared to the total amount to be financed. If you trade-in a vehicle that still has an associated loan balance, the balance will be added to the new loan, increasing the LTV of your new car. Lenders normally deny loans that are more than 115 percent of the value of any vehicle.
Debt-to-Income Ratio (DTI)
DTI is your debt-to-income ratio. This is the total amount of money that you owe for normal debt repayment compared to your gross (before tax) income. When a new loan is being considered, a lender will look at your back-end ratio. The back-end ratio includes all of your recurring monthly expenses…loan payments, rent, utilities, insurance, etc. While each lender has a set amount that you can owe, including the loan being considered, the majority of them will deny loans that exceed a DTI of 45 percent.
Alright, the basic groundwork has been laid, so let’s look at why repaying a portion, if not all, of your current debt load is the best first step toward getting a car loan.
Back to FICO
Looking at the basics of how a FICO score is built, there are several areas that will be boosted if you pay down your debt. First is the amounts owed. This looks directly at the balances reported by your creditors. On your credit report, the initial loan/credit limit is listed as well as the current balance. Each minimum payment lowers that ratio and boosts your credit score a few points. The easiest way to make a major dent in that ratio is to attack credit card debt. If you make a lump sum payment on your lowest balance, your ratio will drop. Try this formula, add all of your credit limits together, then divide that by 10. That number will tell you how much you need to pay in order to drop your total amounts owed on credit card debt by ten percent. Why does that matter? Your score receives the biggest boost if the balances on credit cards are less than 30 percent of the limits on your cards. Dropping your balance by ten percent (the number you just came up with) a month is the quickest way to get to that point.
Addressing the LTV
The surest way to be denied for a car loan is to try borrowing too much money compared to its value. There are two ways to address that issue. First, you need to know the payoff for any vehicle that you intend to trade-in. Next, use kbb.com, nadaguides.com, or any similar site to see how much the average local trade value of your vehicle is. Preferably, the trade amount will be higher than your balance. At the very least, you want them to be equal. If there is a significant disparity, you may want to try one of two plans of attack.
The first is to delay buying another vehicle, but send additional money to your current lender each month. This will save you on total interest on the current loan and lowers the balance more quickly. Of course, that tactic assumes that you do not have a lump sum saved to use for the second plan of attack, which is offering a high down payment. If you can offer a higher down payment, you will immediately lower the LTV.
In order to know how much of a down payment that you will need, you will have to estimate the amount of the total purchase price plus any balance carry over. Compare that to the loan value of the vehicle you want. You can get the approximate loan value from the resources listed above or a local lender. Your target should be any LTV that is under 95 percent. This will keep your monthly payments down, lower your interest rate on the new loan, and give the lender an incentive to offer a longer loan term.
There are certain bills that you can not eliminate. After all, it is not reasonable to assume that you can pay off your mortgage just to get a better auto loan rate. Fortunately, lowering your credit card balances will also lower your monthly payments. If you have any small accounts owed, like medical bills or those Fingerhut and similar accounts, pay those off. You can always look for ways to lower your cable and cell phone bills as well. Every little bit helps encourage a lender to offer you a loan and makes the new payment more affordable.
Paying down your debt is a good idea whether you are considering a car loan or not. By paying attention to the areas mentioned in this post, you can lower the interest rate that you are offered, potentially allow you to be offered a longer loan term, and greatly improve your chances of getting the loan that you are seeking.
This post was co-written by personal finance experts and automotive enthusiasts J. Coffey and T. Brown. You can read more of their automotive-related work over at AutoFoundry.com.