Buying a Car: How Much Car Can You Afford?
The Logic of Money
JANUARY 12, 2020
Have you been limping along with that old junker for long enough? Or maybe, you’re fresh out of college and got that new steady full-time job but need a car to get there? Either way, it’s time to take the plunge and buy that new car and you’re probably asking yourself... how much car can I afford?
Buying a car is exciting, but it can also be a nerve-wracking experience. New cars can cost a mind-blowing amount of money, and used ones can leave you nervous about buying someone else’s junk.
Second to a buying a house (and possibly paying for an education), a car is one of the largest purchases someone will make. That’s why we’ve put together this step-by-step guide to help you determine how much you can afford to spend on a car.
After reading our guide, you will have the knowledge you need to sail confidently through the car-buying process.
Rules of Thumb For Financing a Car
When it comes to buying a car, there are a few rules of thumb to keep in mind to make the whole process a little easier. Here are some of the best one:
New Cars Depreciate Extremely Fast
New cars lose 60% of their value in the first four years, and 20% of that is in the first 12 months.
That means if you buy a brand new car for $35,000, after a year it’s only worth $28,000 on average. After four years, it’s worth just $14,000. This makes a strong case for buying a used vehicle not only because you can get a comparable model for a lower price, but this also prevents you from becoming “underwater” with your car loan.
An underwater loan is a situation that arises when someone buys that new $35,000 car, then a year later they want to sell it. The only problem is that the no-longer-new car is only worth $28,000, but they may still owe $29,700 on it.
The loan balance is greater than what the car is worth, so this car owner would have to shell out an extra $1,000 just to sell the car.
Bank financing is typically cheaper than dealer financing
A car loan through a dealership is generally provided by or sold to a bank anyway; the dealer just does the legwork of filling out the papers for you. And since the dealer has to make money somehow, they charge you for their services or bake the extra charges into the loan terms and fees. This artificially inflates the cost of the loan.
One notable exception to this rule is a 0 percent financing promotion that dealerships run on many new models. You will probably not find a bank that will match that rate.
While financing through a dealership may be more convenient, shopping around for financing may save you a lot of money on interest over the life of your car loan.
Leasing is generally more expensive than buying
If you buy a car, pay it off, and keep it for a long time, you will benefit from several years of not having to make car payments after you pay off the loan.
Leasing - while it typically markets a lower monthly payment - ensures that you will always be making a car payment while never actually owning the car. You also get hit with fees if you go over the allotted mileage, terminate the lease early, or create excessive wear and tear on the vehicle.
Spend 20 percent or less of your after-tax income on car-related expenses
The amount the average American spends about 15 percent of their total expenses on transportation. This includes the cost of gas, oil, registration, repairs, etc.
A commonly held financial rule of thumb is to keep transportation costs under 20 percent of your total budget.
Remember, however, that a rule of thumb is just a guideline. You may have a good reason to go over 20 percent (particularly if the other pieces of your finances are in order). You may live in a snowy area and require a four-wheel-drive vehicle, or you may have a large family and require a car with more seats.
That also doesn’t mean that if your car-related expenses are under 20 percent, then you are doing fine. If you are drowning in credit card debt, student loans, and a mortgage, you may need to spend a little less on a car to make room for those other payments.
Don’t skip out on doing the math for your particular needs and budget and rely solely on this rule of thumb.
Determine How Much Car You Can Afford
What the bank or the car salesperson may say you qualify for may not really work for your budget. After all, the salesperson isn’t going to be the one making your car payments for you. And, considering salespeople work on commission, they get more money when YOU spend more money. Salespeople and lenders have little incentive to make sure you don’t overspend on a car, so spending within your means is all up to you.
Before you head to the dealership or start scrolling through car websites for your new set of wheels, do some quick math to determine how much car you can afford.
Here are the steps you need to follow to figure out how much car you can afford:
Reviewing Your Savings
How much do you have to spend on a down payment? Even though nearly all dealerships will finance vehicles, most will require that you pay some money up front, especially if your credit isn’t great.
Review Your Budget
Make sure you account for all your essential expenses (food, housing, healthcare, savings, phone, etc.). How much room do you have left in your budget for transportation? Remember, your car budget should factor in not just the monthly payment, but also all expenses such a fuel and maintenance. Look for a car that leaves breathing room for your budget.
Estimate The "Extra" Costs of Buying a Car
These costs will include fees, taxes, parking, gas, repairs, and regular maintenance. Subtract what you will spend monthly on these items from the amount you have in your car budget to come up with an estimate for your monthly payment.
Use Our Car Loan Calculator to Determine How Much Car You Can Afford
Now that you know how much you can afford to spend monthly on a car payment, use our car loan calculator to play around with prices, loan terms, down payments, and interest rates to come up with a price range for your car.
Other Costs to Consider Besides Your Monthly Payment
Taking home a new car involves a lot more than just paying the sticker price and driving away into the sunset. Don’t forget to factor these extra costs into your car-buying budget:
It’s not uncommon for documentation, manufacturer, and government fees to raise the price of the car significantly. Some of these fees are unavoidable such as taxes and government fees, while others - like documentation fees, destination charges, and advertising fees - are up for negotiation.
Quick tip: Avoid getting nickel-and-dimed by the dealership by negotiating an out-the-door price, one that includes absolutely everything besides taxes.
While paying 7% sales tax on a bottle of water or a candy bar may not seem like a lot, the cost of the same sales tax on a sedan or a truck can be staggering. Don’t forget to budget for taxes - sales, state, county, etc. - when calculating how much car you can afford.
Check what your state charges for these fees, as they can vary widely from state-to-state. Typically, older cars are cheaper to register than newer ones. Some states require safety inspections as well.
Repairs and Maintenance
Some cars are notorious for their high maintenance and repairs costs. A quick search on Kelly Blue Book or a similar site will help you weed out models with costly repairs and find the ones that have a low cost of ownership in the long run.
A quick phone call or internet search will help you come up with a good estimate of what you would spend on insurance for a particular make and model of car. New cars are usually more expensive to insure than older models, so don’t forget to factor this in when you are car shopping.
Quick tip: if you can combine your auto policy with a homeowner’s or renter’s insurance policy, you will typically get a better bundled rate.
This is probably the biggest, ongoing expense associated with car ownership, and it fluctuates dramatically based on the number of miles you drive, how fuel efficient your car is, and how much gas costs in your area. To get an estimate, simply estimate the number of miles you will drive each week - how far away is work? How far away is the grocery store? - divide your total miles estimate by the miles per gallon of your car, and multiply that by the price per gallon of gas.
If you don’t know how many miles per gallon your car gets, check www.fueleconomy.gov.
If you live in a bigger city, parking fees and permits can be a hefty expense. Make sure to factor in parking permits at school, your apartment complex, work, etc. when you calculate your total transportation budget.
Tips for Buying Your First Car
If You Can Pay Cash, Do It!
The best kind of car payment is no car payment. You will save a lot of money on interest over the life of the vehicle if you never have to take out a car loan. If the car is paid for, you also have the option of liability-only auto insurance, which is cheaper than comprehensive insurance.
Quick tip: if you are planning to pay cash for a car, keep that information close to your chest. The seller will sometimes allow for a lower out-the-door price if they don’t know this, because they will assume there is money to be made off the loan.
Shop Around For Financing
Contrary to popular belief, you don’t have to finance your car at the dealership. Call your local bank or credit union and check their rates; you may be able to get a much better deal, particularly if you have a long-standing relationship with your bank. Most institutions will finance used cars as well.
Check Your Credit Score
Whether you get a loan from a dealership or a bank, your credit score will determine the interest rate on your loan and how much you can borrow. Many banks and credit card companies now allow you to get a copy of your credit score straight from your online banking portal. If your institution doesn’t offer this, check sites like CreditKarma or CreditSesame for a free checkup on your credit score.
Negotiate, Negotiate, Negotiate
Unlike your groceries, the price of your car is always up for negotiation. Dealerships and private owners alike intentionally pad the prices to have some room to come down and make the buyer feel that they are getting a good deal.
When it comes to negotiating, knowledge is power. The dealer isn’t necessarily going to give you a discount just because you asked for one. But if you research the going price for a particular make and model, you will be armed with the information that can convince the seller that the price should be lower and able to explain why.
Don’t Be Afraid to Walk Away
If the price is too steep, the loan terms aren’t great, or that little voice in your head tells you the purchase is a bad idea, don’t be afraid to tell the seller you need time to think about it or to walk away entirely. Many times, stubborn sellers will lower their “absolute bottom-dollar price” while you are on your way out the door if they need to make the sale. Even if you pass on a great deal on a car you love, rest assured that there are plenty of other opportunities and you will certainly find other great deals.
FAQs about Buying a Car
What is the Average Car Payment?
As of 2018, the average car payment for a new car was $554 and the average for a used car was $391. Those averages reflect not only a variety of sticker prices, but a wide range of down payments, loan terms, interest rates, and more. Your monthly payment may be higher or lower, depending on your loan terms. Making sure the payment fits into your budget (with room to spare for the occasional repair) is much more important than the dollar amount you spend each month.
What Percentage of Your Salary Should You Spend on a Car?
A commonly held rule of thumb is that your total transportation costs should not be more than 20 percent of your take-home pay. So if you take home $4,000 per month after taxes, you could theoretically afford to spend $800 on transportation. This isn’t just the sticker price of the car, however. This includes all the little things that we forget owning a car entails like gas, and other repairs and maintenance. Given those numbers, your sticker price should be well below that 20% mark, especially if you drive a lot or if gas is expensive in your area.
How Much Do You Need to Put Down on a Car?
Some car dealerships advertise that they can get you into a vehicle today with no money down. While these offers may seem attractive, it’s a good idea to make a down payment anyway. Here’s why. 1. A bigger down payment = a smaller loan = less interest. The more money you put toward a down payment, the less money you need to borrow, which reduces the amount you pay in interest over the life of the loan. For instance, if you buy a used $20,000 car with no money down, you will pay about $377 a month and $2,645 in interest on a 5-year loan at a 5% interest rate. If you put down a $4,000 down payment, your monthly payment drops to $302 and you save $529 in interest. 2. You will be able to pay your car off faster. Another benefit of a sizeable down payment is to reduce the time needed to pay off the car. Using the example from earlier, if you put down $4,000 on your car, you can make a $368 monthly payment, pay $959 less in interest, and pay off your car in four years instead of five. It’s a win-win-win. It’s a good idea to put at least 10% down on your vehicle, provided that doesn’t jeopardize your savings.
At the end of the day, the best car is simply a reliable vehicle that gets you from point A to point B, for which you can comfortably afford the gas, maintenance, and the loan payment.
If you have to spend a few more months on the subway or scooting around in your junker to afford the car of your dreams, so be it. There’s no shame in that. A shiny, new SUV will be much less fun to drive if you have scavenge among the couch cushions to afford gas.
Keeping your car costs within your budget is an extremely important step to ensure you have a sound financial future.