One of the first questions you will probably ask yourself when you start car shopping is: how much car can I afford? The answer naturally varies by situation. It may also depend on several factors such as whether your old vehicle is worth money as a trade-in or in a private sale, whether you have money to put down on a vehicle and the quality of your credit in getting a loan. It also depends on whether you end up buying new or used, or if you decide to lease.
What Car Can I Afford?
Once upon a time, the 20/4/10 rule was used as a base point to determine the car a person could afford. The theory was that you should make a 20 percent down payment on the price of the vehicle, get a loan with a term no longer than four years and then confirm that your monthly expense on the vehicle, including the loan, maintenance, fuel and insurance, was no more than 10 percent of your income. However, that rule tends to only apply to people with relatively high incomes who only need basic vehicles. When you break down the numbers, it means that someone earning about $59,000 a year would only be able to afford a $20,000 vehicle after putting $5,000 down. It's easy to see why this rule is hard to apply in the present day with many households needing more than one car and earning less than $59,000 per year. A more realistic strategy is to make sure that your monthly loan payment is no more than 15 percent of your take-home pay in a month.
Break Down Your Budget
The first step in determining the answer to the question of "how much car can I afford?" is to break down your monthly budget. Figure out how much you spend every month, including set bill payments, rent or mortgage, groceries, entertainment and anything else. If you're not used to keeping track of what you spend outside of bills, then it might be helpful to track it for a few months to get an idea of the number. Once you've figured that out, you may need to find areas where you can cut to maximize your auto budget. Look for places where you're spending excess money and/or find credit accounts that you might be able to pay off to eliminate that monthly payment.
Calculate Auto Expenses
As previously mentioned, the monthly cost of a car is more than just the loan payment. Similarly, the sticker price of the car you're eyeing includes more than just that number. In order to come up with your auto budget, you need to find some final numbers in these areas. Start with the car's actual price. Loan calculators can help you with this as you add in the sales tax and registration fees to come up with the real price of the car and thus the loan you will need. Next, find out how much it will cost to insure that vehicle and then estimate how much you will drive it and the fuel costs per month. Don't forget to include any routine maintenance you may need to perform in the course of the year and average that out on a monthly basis. Once you have these numbers, you likely have a pretty good idea of the car sticker price that you can afford.
The Average Buying Scenario
In order to look at a budgeting plan in a more specific way, let's explore a scenario. Using the aforementioned income of $59,000, which was also the median U.S. income in 2016, and taking away roughly 25 percent in tax, the monthly take-home pay then becomes roughly $3,700 for this example buyer. Using the 15 percent rule, this buyer could then afford a monthly payment of around $550. The average financing amount for new vehicles in 2017 was $30,796. If this buyer procures a vehicle for that amount, for example a new Ford Explorer, and then puts down 11 percent, or $3,789, with a loan term of six years, the monthly payment will be around $515. Using the example vehicle, its fuel and insurance costs come out to around $260, which makes the buyer's total monthly auto payment around $775. This amount is then roughly 21 percent of the buyer's take-home pay, which is nearly a quarter of their income.
Going Used or Leasing
Of course, not everyone falls into that median income bracket and not everyone has good credit by industry standards, which is how the above payment was calculated. Many people also have additional debt challenges that would make spending a quarter of their income on a car difficult. If you go the used car route, then you would generally end up with a lower sticker price and a lower credit threshold for getting the loan. Again using averages, the example buyer could choose a used vehicle for $21,215 with a 10 percent down payment. The loan would have a slightly higher interest rate, but the payment would be $384 over about 67 months. Fuel costs would most likely be similar, but insurance would be less due to the vehicle being used. This ends up working out to about 17 percent of the buyer's income. Another option would be to lease the previously mentioned new vehicle. This would make the payment still lower at $345 per month and reduce the buyer's obligation to 16.4 percent of their income.
How to Choose
In some cases, your income may be the sole determining factor in terms of what you can afford today. However, if you can look at the long term, then you can make an even more informed decision. If you plan to buy a vehicle, pay it off and then keep driving it for awhile, then buying new or lightly used is a good option. If you dislike the idea of having the same car for well over five years, then leasing is probably a better option. If you simply get rid of your car after a six year loan and buy another with similar terms, you will have paid way more than the car is worth only to do the same thing over again. Leasing allows you to get a new car every few years generally for a smaller monthly payment than buying new or used.
Along with determining your budget, you should determine your own car buying patterns and how your decision will affect your long-term financial goals.