Let me preface this article by saying: don’t be one of those people in the grocery store who pays with EBT or food stamps (there is nothing wrong with social welfare) and then puts their groceries into a Range Rover or Cadillac Escalade (there’s something really wrong with that). Alternatively, don’t drive around with a Bentley and then pull up to a rent-controlled apartment. Just a few recent observations that partially fueled the creation of this post.
With the US auto industry still in recovery mode from recent years of poor sales, now could be a great time to buy a new or used car before demand returns to previous levels. Auto dealerships are continuously implementing better marketing strategies, but before they coax you into buying that sports or luxury car you’ve always wanted, you should first determine how much car you can afford.
Everyone has an idea of what their “dream car” might be, but it’s simply not realistic to prep your garage for a BMW, Mercedes or Porsche when a Toyota Camry or Honda Accord is more within your budget. Before heading to the dealership, there are important questions you need to ask yourself:
- Why am I buying a new car? Is it for functional or utility reasons, or am I “keeping up with the Joneses”?
- How much cash do I have for a down payment? How much cash am I comfortable “investing” into a depreciating asset that will never recoup its original value?
- Do I want to trade in my car? How much is my current car worth? Should I research tips on how to trade in a car?
- How much can I finance with an auto loan? Does it make sense to spend that percentage of my monthly income on a car?
How Much Car Can I Afford?
My personal strategy for determining whether I can afford a car is a little conservative, but that’s because my primary goal in this stage of my life is capital appreciation and growth (aka making money and building my net worth). You can tweak my strategy for your own financial situation. Here is how I determine what car I can afford:
I will only purchase a car when I can afford to pay for it in cash. The reasoning behind this is that, if I can comfortably afford to pay all cash for a car, then I can easily afford the monthly payments and the purchase will not materially affect my ability to invest. Obviously, I would still go ahead and finance most of the purchase price, but again, I would have enough cash in the bank to cover the cost for the term of the loan.
As a general rule of thumb, if you have no upfront cash for a car’s down payment, then you may want to consider waiting a few months before making a big purchase. If you currently don’t have an emergency fund or investments, you should not be buying a new or used car anyway. You should probably also stop visiting Starbucks, going out to eat, hitting Happy Hours, and generally wasting your money. You should live a more frugal life till you create a financial cushion.
Finding other modes of transportation while you build up your savings would be a safer and more financially sound alternative. Unless you have very good or excellent credit, you may not even qualify for a car dealer’s 0% down special, so having a few thousand dollars for a down payment is optimal.
Setting the “new versus used” debate aside, many people agree that you should have at least 20% cash to put towards the down payment, just as you would for a home. Remember, the higher your down payment, the lower your monthly payments thereafter, should you choose to finance the rest. For those with budgets already stretched thin, perhaps you should try to save up to 40% or more for a car down payment, but don’t actually put the 40% cash down.
This will inevitably make you wait several months longer to get a new car, but at least doing so will minimize the impact of monthly payments on your budget and lessen interest payments in the long run. The goal is to buy a car when the payments have a minimal effect on your income.
Of course, you shouldn’t use up all the cash you have in your savings in order to afford the car. Personal finance experts say you should have a cash reserve that can cover a minimum of 6 months of expenses in the event that you experience a financial emergency (i.e. disability, unemployment, natural disaster, etc.).
If you plan on trading in your current car for the new one, your next step is to determine how much equity you have. This involves a simple calculation: how much your car is worth minus how much you still owe the bank for your car loan. So, if your car is worth $15,000 but you still owe $10,000, your trade-in equity is $5,000.
Alternatively, you can sell your current car to a private buyer who will likely pay more than what a dealer would offer you. Unfortunately, this option presents more hassle and risk since you’ll have to advertise, offer test drives, and handle buyers and transactions on your own.
Regardless of whether you sell or trade in your current vehicle, be sure to check out Kelley Blue Book to gauge how much your car might be worth.
Paying for a car entirely with cash isn’t a feasible option for many people shopping for a vehicle these days. It’s a good idea to have a sizeable down payment, but after that, you should consider getting an auto loan.
Auto financing doesn’t need to be complicated, but it will require some research beforehand. The first step is to calculate your monthly budget in order to determine how much money you can comfortably put towards a car payment. If you’re not contributing much money to your savings account and are living at rather than below your means, then you may want to hold off on buying a car for a while.
However, if you are able to save a sizable portion of your monthly income, then it’s generally recommended that your car payments require no more than 15% (preferably less) of your monthly, after-tax income. This way, you still have wiggle room in your transportation budget for gas, car insurance, maintenance and unexpected costs, such as accidents and repairs. This may also be a good time to learn how to save money on gas.
Duration of the Loan
Using the recommendations offered above, if your net monthly income is $4,000, then you should spend $600 or less on car payments each month. Another important factor to take into consideration is the duration of the auto loan. Loans that span over 36, 48, and 60 months are the most popular. The size of payments are inversely related to the length of the car loan, but even if the 60-month loan payments are significantly less, you must always remember that you’ll be paying more interest over the long run.
If you want a basic price range for your car search, then a car payment calculator can offer you guidance. Simply input the monthly payment you feel comfortable with, the car down payment (including both cash and trade-in equity), the APR of the auto loan you qualify for, and the desired duration of the loan (options include: 24, 36, 48, 60, 66, or 72 months). The calculator takes no more than a couple of seconds to determine how much car you can afford.
Some online calculators even include a helpful table that compares car loans based on varied APR and contract lengths. Altogether, the car affordability calculator will undoubtedly give you a good sense of what car you can afford, and ultimately you can use this figure as a standard when it comes time to go car shopping.
Just keep in mind that gas, car insurance, and maintenance costs are tied to the type, make, and model car you buy, so incorporate these financial factors into your budget.
How Much Can I Afford?
Overall, buying a car is not a simple task that can be done in a night’s worth of planning. There are several factors to consider when you decide to purchase a car, such as whether or not you should purchase a new or used one. Most importantly, you should feel confident in evaluating how much car you can actually afford.
While it may be tempting to opt into a dealership special or choose the 60 month auto loan over the 48 month loan, you should understand your budget’s limitations before you step into a dealership or the repo companies are going to appreciate your business.
After further research and thought, you may realize that your best option is to either hold off on buying a new car until you’ve built up your savings or to purchase a smaller and more economical vehicle that is within your price range.