A Real-World Example
To walk through an example, say you’re looking to buy a new car.
1. Contact your bank, credit union or even dealership and research the interest rate you would receive. More than likely, you’ll receive an annual percentage rate, or APR, with a loan term, such as a six percent APR loan that spans five years. They might also give you a maximum loan amount for which you qualify, but this is different than what you’ll calculate from your budgeted monthly payment.
If you were looking for a home loan, the loan term would be much longer, such as 30 years. It’s also important to note that home loans have a variety of loan types, including adjustable rates. This formula only works for fixed rates that don’t change over the life of the loan. Although adjustable rates might be attractive for their low initial payments, there’s also a danger of the payments increasing beyond your budget in the future.
2. Look closely at your monthly budget and subtract your monthly expenses from your monthly income. Spread foreseeable, one-off expenses over a reasonable recovery period.
As an example, if you’re planning a $2,400 vacation next year, you might factor that expense into your monthly budget as $200 per month ($2,400/12 months), so you’ll have enough money saved when vacation time arrives. Also budget in some amount for unexpected expenses and of course savings; it’s always better to have more money saved than needed, than to have expenses you don’t know how you’ll pay.
In this example, say you’ve assessed your budget and find an extra $400 per month.
If you were buying a house, you’ll also need to subtract a reasonable escrow fee and possibly mortgage insurance, which your bank or credit union can help you assess. These items are typically added to the calculated monthly payment to cover taxes, insurance and such.
Therefore, to ensure your actual monthly payment coincides with the one you budgeted, you’ll need to factor in these extra expenses now. You might also need to research and factor in any home owner’s association dues or regime fees that sometimes arise when you buy a house.
3. Plug your data into the above formula. In the example, the formula becomes: