Like it or not, having wheels at your disposal makes life easier, whether you’re schlepping groceries, commuting to the office, or carpooling to a concert. But figuring out how much you can afford to spend on a car can be a real challenge, especially for first-time buyers.
“A car is the second biggest purchase most of us ever make, and it’s not something that needs to be done quickly,” says Sonia Steinway, co-founder of Outside Financial, which specializes in auto loans.
Not sure where to start? Here’s some clear advice to help you decide not only how much you can afford to spend, but also whether you should buy used or new, and why it's a good idea to keep your transportation costs low.
Let Income Guide Your Car Purchase
Your gross income (that is, your before-taxes earnings) is the first, best tool to determine what you can afford.
Dakota Brizendine, partner at Commonwealth Financial Group in Burlington, VT, shares a simple rule of thumb: If you make $100,000 or less, your car payment, interest, and insurance should not exceed 8 to 10 percent of your income.
Say your income is $50,000 a year. That would put monthly car expenses (not including gas) at $417 a month—or lower.
With a higher income, her recommended percentage for car costs dips even further. “If you’re making over $100,000, we generally want to see transportation come in at 5 to 7 percent of your income,” says Brizendine.
Too much math? Use an online car affordability calculator to help you see the breakdown.
Determine What You Can Borrow
If you’re not buying a car with cash, you’ll need to take out a loan.
“It’s really easy (and smart) to get pre-qualified for a loan before going to the dealership,” says Steinway. That’s because many dealers markup loans, says Steinway—to an estimated average of more than $1,700.
You can get a loan through many financial institutions, but if you belong to a credit union, or can join one, take a look at their rates.
“I’m a big advocate of using a local credit union if you have one—often they can offer very competitive rates,” says Brizendine. These rates, she adds, may be better than what you’d get through your dealer or a major bank that you don’t have a history with.
Whether your financing is through a bank, dealership, credit union, or any other financial institution, lenders take several factors into consideration when creating the terms of the loan. These three C’s are:
1. Credit score: Having a healthy credit score (700 and above) will help you get a better rate when you borrow money.
2. Collateral: Lenders use the car's value, or collateral, it to calculate the loan-to-value ratio—the size of the loan divided by the appraised value of the purchase—to help determine the risk of the loan.
3. Capacity to pay: Reasonably enough, lenders want to feel confident you won't default. To assess, they’ll use your debt-to-income ratio and payment-to-income ratio to evaluate how much income you have available to pay off the loan.
All lenders weigh these three factors slightly differently—that’s why not all loan offers are the same. And if you’re financing the purchase of a used car, take note: “Rates for used cars are typically slightly higher than for new cars,” says Steinway.
Put Money Down If You Can
You can still get a car if you don't have the cash on hand for a down payment (just think of all those car commercials trumpeting "zero down"). But the more you put down, the less you’ll have to borrow (and pay interest on). And, notes Steinway, making a down payment “shows lenders you're serious about paying back your car loan, so it can increase the likelihood of getting good loan offers.”
Don't Forget to Factor in Future Expenses
Along with your monthly car payment, you can expect several other expenses as a car owner: insurance, tolls, fueling up at the pump, and routine maintenance are the biggies.
And then there are unexpected bills—you may, for instance, get a speeding ticket or a flat tire. An accident can mean expensive repairs. Big things can break, which again will require repairs.
Budget for these expenses, keeping in mind that both repair and upkeep costs can vary from one vehicle to another, says Steinway. To get a sense of the variation, she says, use an online total cost of ownership calculator (such as this one from Edmunds).
Say you can afford the very best car—a luxury vehicle, with exciting and tempting features. Should you get it?
According to AAA’s annual Your Driving Costs study, depreciation is the biggest cost of car ownership, often amounting to $3,000 per year for new cars.
“To put it in layman’s terms, cars are money sucks—there’s nothing about them that’s going to appreciate in value over time,” says Brizendine.
Unlike a home, artwork, rare vintage collector car, or a stock purchase, your car’s value only goes down—never up. It won’t add value to your net worth or increase your cash flow, says Brizendine. “From a financial planning perspective, there’s not a lot of upside, which is why we want to keep it to a really reasonable rate that you’re spending on your car.”
Should You Buy New or Used?
Once you nail down the amount you can pay, the fun part comes next: picking a car. But should you buy new or used?
"I strongly advise against buying new cars," says Brizendine, who recommends her clients purchase well-vetted used cars instead.
The bottom line for Brizendine is that saving—she recommends socking away 15 percent of your income—should be the biggest priority, not car payments.
"People notoriously overspend on their vehicles," she says.
Make smart choices, whether you're buying, selling, insuring, maintaining, or repairing a vehicle.