Reality Check: How Much Car Can You Afford

How much can you really afford to pay for a new or used car?

Calculating how much you should spend on a new or used car is a very important step in budgeting and financial planning.  Believe me, when it comes to monthly car payments and affordability, banks will let you borrow far more than you should ever think about borrowing.

bmw memeIdeally, you should save up and pay cash for a used car.  Not only will you avoid paying interest on the loan, you’ll be in an excellent position to negotiate a good price on the car (especially if you’re buying a used car in a private party sale) and avoid the swift depreciation that comes with driving a new car off the lot.

The problem for most people is they usually end up replacing their current car unexpectedly without saving up an adequate amount of money in a car replacement fund.  Cars break down, families get bigger, job commutes get longer, gas prices increase, there are many reasons people justify needing or wanting a different vehicle.

If you’re wondering how much car you can afford, here’s a few general rules of thumb to help you decide if you’re buying more car than you can afford.

1) AVOID 60 Month, 72 Month and 84 Month Auto Loans:

Never get more than a 48 month term on your car loan.  The problem with car loans that are stretched out over 72 months or even 60 months is the car depreciates in value so quickly that the buyer typically owes more on the car than the car is actually worth over the first 4 or 5 years of the loan.

Compounding this problem is the fact that most people don’t keep their cars any longer than 4 years and they end up trading their car in on another new car and roll that “negative equity” into their next car loan (and this viscous cycle goes on and on…). Paying back your car loan over 5 or 6 years will keep your monthly payments low but chances are you’re spending way too much on a new or used car if this is the only way you can keep the payment within your monthly budget.

But What About 0% Interest Loans, are they a Good Idea:  In my experience, 0% interest loans are usually offered in lieu of taking a cash rebate discount up front.  If you can get a 0% interest loan on a new car (0% loans are not available for used car with the exception of some certified pre-owned models)  for the same price you would have paid in cash, then “technically” you could come out ahead by taking the 0% interest loan and investing the remaining funds in a certificate of deposit, money market account, or low risk mutual fund.  But lets face it, most people don’t have the discipline to do this. Instead, the money gets wasted on other things.

2) Buy Within Your Means and the Effects of Depreciation:

Another financial rule of thumb when it comes to buying your next car is that the total value of all your vehicles (cars, boats, atvs, motorcycles, RVs, etc,) shouldn’t add up to any more than half your annual income.  In other words, if your household income is $60,000 the value of all your “toys” shouldn’t be anymore than $30,000.  Any higher than this, and you’re losing too much in depreciation each year in relation to your income.

If you have $30,000 worth of vehicles sitting in your driveway, chances are next year the value of those vehicle will be around $25,000.  That $5,000 in depreciation ends up eating a large part of your income (8.3%).  You’re basically paying an 8.3% “tax” in depreciation every year (maybe now you’re starting to see why you’re not getting ahead financially).  The higher the value of all your vehicles, the higher this depreciation “tax” and the less money you’ll have left over to save for retirement, paying off your house, or saving for you child’s college.

3) Monthly Payment Affordability:

In a perfect world, we’d all buy the least expensive cars possible that fulfilled our transportation needs (but we know this is not reality).  As I mentioned above, you need to be very careful with monthly payment amounts on automobile loans.  Dealerships work hard to get you to focus on a monthly payment by asking you what you’re comfortable paying each month.  Once they have this number they’ll often try to pad their profits by packaging a lot of extras into the loan (extended warranties, document fees, loan origination fees, window etching, fabric protection, etc.) and then stretch the loan out over as many years as possible to meet your monthly payment target.

Keeping that in mind, you still need to have a reasonable monthly payment especially if you take the high road getting a shorter term auto loan (48 months or less).  My suggestions is to take a hard look at your monthly budget and figure out how much discretionary income you have left over at the end of the month and what you’d be comfortable paying each month.  A general rule of thumb (if you can’t pay cash) is to spend no more than 5% of your monthly gross income on car payments.  If you earn $2500 in income per month, your car payment shouldn’t be any more than $125.  If you make $10,000 per month, your car payment shouldn’t be any more than $500.

Good luck in your car shopping and please feel free to leave comments in the form below!

 

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