How Much Can I Afford to Borrow?

The maximum amount you can afford to borrow depends on three things: the annual interest rate of the home or car loan, the number of months in the loan period, and how much you can afford to pay each month. If you are shopping around for auto loans or home loans, this article will show you how to hand-calculate the maximum amount you can afford to borrow. You can also use the mortgage calculator at left.

First, estimate the annual interest rate you are likely to secure. If you have good credit, you may be able to obtain a rate as low as 5% or 6%. If you have poor credit or no credit, your rate may be 9%-12%. Call the annual interest rate R. Call the number of months in the loan period N. Lastly, estimate the maximum monthly payment you can make for N months. Call the monthly payments M.

Use the financial equation below to calculate P, the maximum principal you can afford. (Principal is another term for the amount of money you borrow.)

         M[(1+R/12)^N - 1]
P = -----------------------
         (R/12)(1+R/12)^N

If you don't know the precise interest rate you qualify for, test the formula with a range of values for R. All things being equal, the higher the value of R, the less you can afford to borrow. The lower the interest rate you can secure, the larger the loan you can take out.

Here is an example you can use as a guide. Suppose you want to borrow money for a car; you are able to pay $300 a month for 4 years, and you can get an interest rate of 9% with current your credit. Then M = 300, R = 0.09, and N = 48. Plugging these values into the formula yields:

P = 300(1.0075⁴⁸ - 1)/[(0.0075)(1.0075⁴⁸)]
= (300)(0.43140533)/[(0.0075)(1.43140533)]
= 12055

With these loan terms you can afford to take out an auto loan for $12,055.

© Had2Know 2010