Everybody loves cars! Or at least the idea of travelling or driving in luxury appeals to most of us. Apart from houses, cars are the next biggest purchases that we make in our lifetime.
Buying more car than you can afford is one of the most expensive and common financial mistakes.
There is no hard and fast rule about how much you can spend on a car. Personal finance is always PERSONAL, it depends on your individual needs.
None of the “rules” and calculators online will take your loans and debt obligations into consideration. And they certainly won’t take your savings goals or retirement goals into account. In short, none of YOUR needs are accounted for. So you need to think for yourself.
But I’ll help you by providing all the research in one place so that you can make your PERSONAL decision.
DON’T GET FOOLED BY MONTHLY PAYMENTS
Dealerships know exactly how to sell you a car that’s way out of your budget. They make the car payment sound super affordable by advertising that it’s only $660 a month or $165 weekly!
And you may think, I could spare $660! But take a step back and assess the actual amount of the car loan that you’re signing up for.
At a 5% interest rate and a loan term of 60 months (average values in the US), the auto loan amount would be $35,000.
After 5 years of depreciation, you would lose $21,600 on the car’s value. That’s money that you will never see again.
Another $4600 will be lost in interest fees. This amount is not even used toward the car, it’s just bank fees.
Instead, imagine that you invested those depreciation costs and interest fees of $26,200 in the stock market, in some low risk option like the S&P 500. After 5 years, your account would be worth $44,000!
Your money would have literally earned you $18,000. Isn’t that mind blowing?! 🤯
So, don’t let yourself get swindled by just looking at the biweekly / monthly payments! Look at the total price of the car and decide whether or not it’s affordable.
OWNERSHIP COSTS
When you are evaluating a car’s affordability, make sure to take the cost of ownership into account.
This includes the costs of car maintenance like oil changes, fuel costs (some cars require premium fuel), costs of winter tires and set of extra rims etc.
Also estimate the cost of car insurance for the models that you are considering.
If you plan to sign up for extras such as extended warranty, rust warranty or gap insurance, factor those into your target price too.
Lastly, add the sales tax, license and registration fees, and loan interest fees to your car budget.
If you are paying cash for your car, you can skip the interest charges. But if you plan to finance your car, check the interest rates that you qualify for based on your credit score and calculate your interest fees.
It might sound like a lot of work but dropping thousands of your hard-earned dollars on a car warrants some research! 😃
THE NEW vs. USED DEBATE
The short answer is that used cars are a lot cheaper to own! This is because new cars depreciate at a much faster pace.
New cars lose 10% of their value in the first minute of ownership and their value drops by more than 20% in the first year.
I could never wrap my head around that! So I’ve always bought pre-owned cars. Personally, I wouldn’t buy a new car unless I’m earning a million dollars! 😁
Used cars are priced much lower because the first owner pays off a big chunk of the depreciation losses.
If you decide to buy pre-owned, do your research and look for car models that are low maintenance. It’s certainly a lot safer to buy your car at a reputable used car dealership than from a small dealership.
When shopping for a used car, make sure to test it and get a thorough inspection done before buying it.
If you plan to purchase a car cheaper than $6000, definitely get an assessment of its mechanical state and safety.
DOWN PAYMENT
A general rule of thumb is to put 20% down on your car purchase. If you can truly afford the car, you should easily be able to pay this.
If not, it might be worthwhile to pause and take the time to save up for a down payment and then revisit your car purchase. In just 7 months, I was able to boost my savings to $25,000 by creating a conscious budget!
Otherwise, you could also lower your car budget to better fit the down payment that you can afford.
When you are buying a new vehicle, paying 20% down keeps you from owing more than your car’s value on your auto loan. As new cars depreciate by about 20% in the first year, with zero down payment, your auto loan’s principal would be larger than your car’s value at the end of the first year.
There are advantages to putting 20% down even if you are buying a pre-owned car. You could qualify for better interest rates and easier loan approvals.
Moreover, paying 20% down will reduce your monthly payments and the interest fees you owe on your car loan.
LOAN TERM
Many people are tempted to take longer loan terms because it lowers their monthly payment. But the longer your loan term, the more interest charges you end up paying.
Longer terms usually come with a higher interest rate. So even though they seem to offer you a more affordable monthly payment, they ultimately cost you more.
So, don’t just view this from the monthly payments perspective. Look at the full picture. You’ll realize that there is no upside to taking a car loan that is longer than 6 years.
20/4/10 RULE
Some experts suggest the 20/4/10 rule to help you narrow down your target monthly payment amount.
The rule recommends a 20% down payment with a loan term of 4 years. And the total monthly car payments (loan + insurance) should not be more than 10% of your gross monthly pay.
Some articles interpret this rule to be 10% of your net (take-home) monthly pay. But as with all rules, it depends on how conservative you are with your finances.
1/10th RULE
Another popular rule states that the price of your car shouldn’t be more than 10% of your gross annual income.
This is a good way to ensure that you can afford the car purchase but many find that the rule is a bit too frugal.
But the truth is that all these “rules” were written for those who are still in debt or those who are still on their financial journey and saving for retirement.
Following this rule relieves a lot of stress associated with car ownership. Since the price will be quite affordable, you could buy the car with cash and never have to worry about a loan.
THE SSS RULE
This is my personal favorite. I call it the SSS rule, it stands for Save / Spend / Splurge!
This rule understands that how much car you can afford depends on your personal financial priorities. So YOU get to choose which category you identify with.
SAVE: Are you a follower of the FIRE movement or do you have goals to retire early?
This category is for those who have a goal to achieve financial freedom and don’t want to work extra years just so they can drive a fancy car to their 9 to 5 jobs. Being frugal will be your ticket out of the rat race!
The recommendation for this category is to spend no more than 10-15% of your gross annual pay.
SPEND: Do you have important savings goals like saving for a house’s down payment? Do you have debt payments like student loans, credit card loans and plan to become debt free?
Those who identify with this category understand that cars are a depreciating asset and that their money deserves to be invested where it can actually earn them returns.
The recommendation for this category is to spend a maximum of 15-20% of your gross annual pay.
SPLURGE: If you are well on track for your retirement or savings goals and are more or less debt free, then of course you could choose to splurge more on your car. You’ve clearly been smart with your money, well done! 👏🏻
This category also applies to gearheads for whom cars are a top priority! It would be prudent to reduce your spending in other entertainment categories to balance the budget dedicated to your car.
You could choose to spend anywhere between 20-50% of your gross annual pay if you identify with this category.
Here is a sample table to show you how much you could choose to spend on your car based on your annual income and lifestyle.
If you find that your target price is too low to find a reasonable vehicle, it might be worthwhile to consider other alternatives. Ridesharing, public transport, carpool, cycling and walking are all excellent alternatives to owning a car.
When Anoush moved to Chicago, she chose to live close to her work and took an Uber everyday. Her monthly costs were about $300 which is close to what I paid when I commuted by public transport.
PARTING WORDS
Now that you have all the information in your hands, it’s time to decide your target price.
- When thinking of a car’s affordability, don’t just look at the monthly payment. Look at the total cost of the car and consider how much you can afford.
- Evaluate if you can buy your car with cash or think about how much down payment you can afford.
- If you are financing, check the interest rates that you qualify for before you head out to the dealership.
- Plan for a shorter loan term.
- Calculate your cost of ownership by adding the sales tax, license fees, interest fees, car maintenance costs, insurance and fuel costs.
- And lastly, based on your salary, debt payment obligations and your lifestyle, nail down your TARGET PRICE.
My parting words would be that car purchases can easily be driven by emotions. But it’s important to stick to your math because the numbers never lie! Do your research, follow your budget and you’re bound to have a stress-free car ownership. Good luck! 😁