The way to decide which car you should buy depends on your needs and how much you love cars. If you think of cars only as a necessity without bothering about them being a status symbol, you should ideally spend 10% of your annual income. If you want reliability and a car that would last a decent amount of time, you should spend 20% of your annual income. If you love cars and value them more than any of your possessions, spending up to 50% is also justifiable.
How much car payment can I afford?
Although there are a lot of resources both online and offline that offer lots of guidelines and various calculators, the only way to calculate how much car payment you can afford is based on how much you earn and what is your monthly expenditure. You earn a certain amount of money and spend it on a variety of things including food, rent, utility bills, travel etc. The rest of the money that you save each month can be invested in a lot of things and saving for a car could be one. There are many added expenses to the price of a car that is not shown in the commercials and there are different kinds of government fees which you need to pay like sales tax, registration fees which add around 10% to the price of the car. Moreover, companies advertise the base model in unpopular colors. So the car you would actually like to buy is usually a couple of thousand dollars more than the base price. Some car companies add extra features on the car such as chrome wheels, alarms etc and later add them to the cost of the car. So it is very important that you check each and every element of the car price and pay for the add-ons only if you need or want them. When you purchase a car, the salesman in the showroom will try to sell warranties and different kinds of protection plans at an inflated price, that you may not need and at times the plans they offer are not useful at all in the first place. Another important cost you should consider while buying a car is the cost you would incur after the purchase which includes repairs, maintenance, depreciation and gas expenses which are easy to overlook but could affect your budget if not taken in to account.
The most popular rule when it comes to car financing is the 20-4-10 rule. According to this rule, when you consider buying a car, you should pay a down payment of at least 20% in cash, The car loan should be taken for a period of no more than 4 years and lastly, you should keep the monthly loan payment to 10% of your monthly income.
What is your budget?
Deciding the budget of your car loan is a very crucial decision and sticking to it is also important. It might be possible to get swayed by fancy car commercials and deciding to buy a car totally out of your reach can have dire consequences on your personal finances. Another point to keep in mind when deciding the budget of the loan are the taxes and fees you will have to pay. So keep a margin of around 10-15% on your loan for this. The car loan should not hit the home economics in such a way that you are not able to spend on leisure activities anymore. Account for everything like rent, food, travel, utilities, the internet, home loans or any other monthly expenditure. Keep some buffer amount every month for emergencies, vacations or any retirement plan you have. If you are not able to save much for the car at the end of each month, start looking at your credit card and bank statements and see where you can cut the unnecessary expenditure or anything else you feel that can wait. Although the 20-4-10 rule is a very smart way to invest in a car, it is not feasible to stick to it in today’s world. The main reasons for this are: cars are quite expensive and cost associated with its purchase are too high and with the expenses these days, it’s hard to save a lot of money for the down payment on the car. The average term of loans is not 5.5 years and a considerable chunk of loans stretch to as long as 7 years. Such a long term for loans is not a smart way to finance your car unless you pay a lot more than 20% of the total price as down payment. Each extra year you add to repay the car loan, the more interest you pay making the car much more expensive than its current value.
The 20% rule
According to experts, any new car loses 9% of its value the moment you buy it. At the end of the first year, the value depreciates by 19%. That is why a down payment of at least 20% should be paid so that you don’t owe more than the worth of the car. Your monthly car payment primarily depends on two factors: your down payment and the time period of the car loan. Also, keep in mind that the monthly expenditure on the car including the loan payment, gas, repairs etc should not exceed 20% of your monthly income otherwise your savings and other expenses might face a hit. If you really want a car exceeding your budget then you need to start cutting down other expenditures which you feel are not urgent and start spending economically.
To illustrate the 20% rule, let’s assume that your monthly take-home income is $5,000. This means that no more than $1,000 should be spent on the car including monthly loan payment, gas, repairs, insurance etc. You can ideally keep $600-650 for the car payment and the rest for the other expenditures.
Calculate your monthly payment
The total car payment including the interest, principal and insurance and excluding other car related expenses should not be more than 10 percent of your monthly take-home income. Keeping more than 10% for the car payment would result in you being able less money as other expenses like utilities, rent, food can’t be compromised. Also, you won’t be able to reserve money for emergencies or any other unforeseen situation.
You should calculate the total monthly expenditure and after keeping the money as savings and emergency fund, decide the highest amount of car payment you can easily pay. While talking to the car salesman about your car payments, do not disclose this amount as he/she will try to use it to lure you into buying the most expensive car you can with this amount. There are many ways by which he can do this: One way is to show you the cars that are out of your reach but towards which you will take an instant liking. Another way which is much simpler is to extend the time period of the car loan. This will allow the car dealer to get more interest out of the loan, putting you to an obvious loss and a serious financial problem. Making an assessment of your monthly paying capacity can also help you in deciding whether to even buy the car or not or postpone it till you can afford higher down payment. After this calculation, you might realize that you can afford only a cheaper car than you had earlier decided to buy. The car dealer will always try to offer you the lowest monthly payment so that you pay less each month. While it may sound good that you have to pay a less amount but you will end up paying much more because, the longer the money is unpaid, the more interest you will have to pay.
Things to consider before deciding on the car price
- The term of the repayment of your car loan should not be more than four years. Although this is the ideal time period, due to a lot of factors, car loans are stretched out to a period of 5 years. The only reason for having a shorter term is the interest. The longer the time of repayment, the more interest you will pay. Also, as the car loses value each year, you might end up paying much more than what you owe.
- You should be absolutely certain of which car you want to buy before you enter the showroom. If you are uncertain about buying a certain car, dealers would most likely try to take advantage of this. They will try to sell you a car higher than your budget and will nearly successfully convince you to take the loan for a higher time period to afford the car.
- Honestly and accurately assess your budget and stick to it. Buying an expensive car may act as a status symbol and have a lot of other benefits but going overboard and committing to something you won’t most likely be able to follow will be very harmful to you.
- Consider your decision of buying a new car altogether. It might be the case that your old car is now a few years old and you are bored with it or a new car model has caught your fancy. A better idea would be to assess the condition of your old car and decide if you really need a new one or the old one would work just fine with a few repairs, clean-up and repainting
- If you have finally considered selling your old car and buying a new one, you should clean-up the interior and exterior of your car to improve its overall look. This will cost no more than $50-60 but will add hundreds of dollars to its resale value.
- You should always research well before going to a car dealer. Find out the best schemes that are available for car payments. Based on your calculations, decide the amount(including interest) you will be willing to pay each month. You can secure a loan even before you go for buying a car. So, in this way if you already know the monthly payment you will have to incur, the salesperson would not try to talk you into buying a car outside your budget.
- Don’t get lured into buying an expensive car if the salesman tries to show you low monthly payment options as you will be paying much more than you intended to due to stretched out loan term. You will be paying interest on the loan for a longer duration, increasing the total amount that you will repay.
- Always take a test drive of the car before you decide to buy it. You should feel comfortable while driving it. Don’t get swayed by the loan terms or any other factor and miss the test drive. Buying a car is a very big and important decision that you make, so you should make it with complete certainty leaving no room for regrets.
Let us try to understand the whole scenario with an example. Suppose you make $60,000 a year. Let’s say after paying taxes at 10%, the net take-home is $54,000 annually or $4500 monthly. This means that the cost of your car including the taxes and the fees should not be more than $10,800. Let’s say that you decide to buy a car with a final price of $10,000. So according to the 20-4-10 rule, you should make a down payment of $2,000. The monthly car payment should not be more than 10% of the monthly income or $450. Median car insurance rate is around $1,200 per year or $100 monthly. If gas costs $100 a month (depends on the use) and other costs are around $50 per month, the total car ownership cost is $700 per month or 15% of the monthly income. This leaves you with $3800 each month for all the other expenses. Consider a hypothetical interest rate of 5% annually, you can pay the loan of $8,000 dollars in just 18 months paying less than a couple of hundred dollars in interest. If you would have spent 30% of your annual take-home income or approximately $16,000, the car monthly car payment would have been the same, $450 along with the rest of the costs. You would have to make a downpayment of at least $3,200 and taken a loan of $12,800. The repayment would have taken 30 months with the interest amounting to almost double than that in the previous calculation. To prevent this, you would have opted for a higher monthly payment plan but that would have had put your entire monthly budget in a jeopardy.