How Much Should You Spend on a New Car?
Unlike many other expenses, you're in the driver's seat when it comes to the cost of a new car.
If you live in an expensive area like New York City or San Francisco, you'll probably pay a lot for housing, but you don't have to spend a lot, or anything, on a car. You have plenty of mass transit options, after all. But if you live elsewhere, you don't have to pay a lot for a car, either. You don't need all those options, a ton of horsepower, or the largest vehicle. Most car salesmen are paid on commission, so they're motivated to sell regardless of whether or not you actually need — or can afford — the vehicle. (See also: 17 Things Car Salesmen Don't Want You to Know)
Unfortunately, too many middle income families purchase vehicles they cannot afford. A study by Interest.com shows that median income families in all but one major city, Washington, D.C., cannot afford the average price Americans paid for new trucks and cars.
The website's 2013 Car Affordability Study used the 20/4/10 rule (more on that, below) and data on income, auto insurance, and vehicle sales tax rates from the U.S. Census Bureau, the National Association of Insurance Commissioners, and other information sources to determine what median income families in the largest 25 metro areas should spend on new vehicles.
It found that affordability ranges widely. For instance, median income car buyers in the Washington, D.C., area could afford $31,940, enough for a luxurious BMW X1 crossover, while buyers in Tampa, Fla., could afford just $14,516, enough for a subcompact Chevrolet Sonic.
The variations are due to wide ranges in incomes, tax rates, and car insurance. For example, median incomes range from $86,680 in Washington to $43,832 in Tampa. Sales taxes range from 9.8% in Seattle to 0.0% in Portland, Ore.
“What this research indicates, more than anything, is that a lot of Americans are spending too much money on their cars,” says Mike Sante, managing editor of Interest.com.
Use the 20/4/10 Rule to Control Car Expenses
How to you know if you can afford a new car? The answer is the 20/4/10 rule.
In a nutshell, the rule says buyers should:
- Put down at least 20%
- Finance the vehicle for no more than four years
- Keep total monthly vehicle expense — including principal, interest, and insurance — under 10% of gross income
Let's take a closer look at each of those rules.
Putting 20% or more down makes sure you don't assume a loan that's too large. A significant down payment reduces the amount of interest you'll pay by reducing the size of your loan. If you lack 20% of the price, in cash, it's a sign the vehicle is too costly for you.
Finance for No More Than Four Years
Lenders may offer longer loan time frames, but they're not to your advantage.
The longer the repayment period, the more costly the loan and the longer you wait before the car becomes yours. A shorter loan also lets you cancel expensive collision and comprehensive insurance that lenders require, but you may not need. The common guideline is to drop collision insurance if your car is worth less than $3,000 or the annual premium is 10% or more of the car's book value.
Total Expenses Under 10% of Income
You shouldn't put more than 10% of your monthly income into a vehicle. Less than 10% is even better. In fact, less than about 30% of your income should go toward repaying all of your loans put together. Lenders may offer loans with longer terms, as well as loans with no down payments, but that doesn't mean you should accept those offers.
Of course, the 20/4/10 rule is only a guideline, not a rule set in stone. Another guideline says car expenses, including car payments, insurance, and repairs, should not exceed 20% of your monthly take home pay.
Instead of using formula as a one-size-fits-all template, use it as a guideline but also understand your expenses, talk to different lenders about loan options, and be honest about what you can afford.
Are you in the market for a new car? How are you determining your budget?