Once you have decided that you need to buy a car, the first step is to determine how much car you can afford based on a monthly loan payment.
How Much Car Can You Buy?
Most people first decide on what car they want to buy and then find a way to finance it based on the monthly loan payment. Since the average price of a used car is now over $20,000 and the average price of a new car is now over $35,000; the only way many buyers can afford to buy a car is by financing it with a 60-month, 72-month or 96-month (8 years!) loan. These long-term loans will leave you owing more on the car than its value over most of the length of your loan.
This process of buying a car is backwards.
The first step in buying a car should be determining an affordable monthly loan payment. Then go about finding a car to buy that fits your budget. Remember, you are not making an investment. You are buying a car and it will rapidly depreciate in value.
Methods of Determining Affordable Car Payments
Experts have different ideas of how to best determine your car-buying budget. Let’s take a look at a few popular methods for determining how much you should spend:
No more than 15% of your monthly take-home pay
This option are for those individuals whose only other debt is a mortgage. That means you don’t have any credit card debt, a student loan, or a loan for anything else.
$3,000 x 15% = $450 Maximum monthly car payment allowed
However, this option has an additional guideline. Your total auto expense should not exceed 22% of your take-home pay. Total auto expense includes:
- Car loan payment
$3,000 x 22% = $660 Maximum total auto expense (Monthly)
Total debt payments should not exceed 36% of your total monthly gross income
This method considers all of monthly debt payments. Take a look at this example:
$ 4,000 Monthly gross income
$ 1,440 Allowable monthly debt payments (36% of monthly gross income)
$ 800 Less for monthly mortgage payment (or Rent)
$ 250 Less for monthly credit card debt
$ 200 Less for student loan debt
$ 140 Monthly amount left over for a car payment
This method quickly shows you if you can afford to buy a car right now.
Half your annual gross income
Let’s assume that your annual salary is $60,000. That means you are supposed to be able to afford a $30,000 car. Now it comes down to whether or not you can afford the monthly payment for a $30,000 car. Let’s look at the numbers:
$ 33,000 Sales price of the auto
$ 3,000 Less down payment (cash or trade-in)
$ 30,000 Amount to be financed (60-month loan at 4.50% interest)
$ 559 Monthly car payment
$ 6,708 Total payments for 1 year
11.2% Of your annual gross income
Now let’s add the additional monthly costs of insurance, fuel and maintenance
$ 559 Car payment
$ 400 Insurance, fuel and maintenance
$ 959 Total monthly auto expense
$ 11,508 Total annual auto expense
19.2% Of your annual gross income
Based on the example above, it appears that your monthly car payment and total auto expense are affordable. However, the interest rate will be higher if you don’t have an excellent credit rating and insurance will be higher if you have any violations or accidents on your driving record for the last 3 – 5 years.
The 10 / 20 Rule (My Recommendation)
This is the most conservative method. It’s purpose is to not allow you to get in over your head. This method, above all others, has your financial well-being in mind if you need to finance you car. This method equates to:
- No more than 10% of your take-home pay should be allocated for a car payment.
- No more than 20% of your take-home pay should go to the total of the car payment, insurance, fuel and maintenance.
$ 3,000 x 10% = $ 300 maximum monthly car payment
$ 3,000 X 20% = $ 600 maximum for the total monthly car expenses
The ultimate goal is to be in such a financial position that you can pay cash for a car and won’t need to borrow money for it. I’ve paid cash for the cars I’ve bought for the last 24 years. It just doesn’t make sense to me to finance and pay interest on a car that will rapidly depreciate in value and be worth almost nothing by the time the car is paid off.
I realize that it takes time to attain this financial position in life. So … if you must finance your next car, do it smartly and don’t let yourself get buried with additional debt that is truly beyond your means repay.
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