How Much Should You Spend on a New Car?

by Michael Kling on 4 April 2013 14 comments
Photo: RBerteig

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.

20% Down

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?

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Guest's picture

If your car is working right now and is meeting your basic needs, it's much better to spend four years paying yourself an imaginary car loan and then buying a car outright at the end of that time. After you get your first set of wheels, car debt is usually unnecessary risk exposure as well as an unnecessary expense. If you pay in cash, you're far more likely to buy a car you can really afford rather than choosing a car with car payments that you can make--but can't really afford.

Guest's picture
Josh

That's really solid advice Jenny. I did exactly that a few years back and it turned out great. That being said, I don't drive an especially nice car. It looks good, drives well, and gets me where I need to go, but it isn't fancy or luxurious. I only use it for commuting, so that doesn't matter to me at all. However, I know different people have different standards, so it may take a bit more than 4 years.

Guest's picture

Being someone from DC who currently goes to school in Tampa, FL, I am not surprised by that statistic at all. The cost of living and pay is much higher up north than it is in the south, so it isn't surprising that people make and have the extra money to spend on a nicer vehicle.

Guest's picture
Guest

poor advice... how about never buy a new car unless you can pay cash for it? it's the worst investment one can ever make. i would never advise someone to finance a car. sorry, dont agree on this one.

Guest's picture
Derik

Not everyone has that option. Not everyone lives in a city with good public transportation, and some careers require dependable transportation. If that transportation affords someone a great job/career, it could be the BEST investment one could make. I think each person should evaluate the expense from a comprehensive perspective.

Guest's picture

Personally, I feel people should pay cash for vehicles and skip the finance option. Many dealerships sell cars as a means to sell loans, because that's where they make their money!

Buy what you can afford (aka, with money that's already in your checking account). Old cars can be great cars – no need to buy new unless you're rolling in the dough. :)

Guest's picture

I'm not sure about the financing option or not. A car is an investment that immediately begins to depreciate the minute you drive it off the lot. Paying cash would seem like the better solution because if you can do that it means you can actually afford it while other options mean you don't have the means or financial stability to be buying a new car and should choose a different option.

Guest's picture
Guest

We pay cash, and keep it for as long as possible. I at least try to make it to $2000 a year, not including maintenance. For instance, our current vehicle was $28k, I've had it for 9 years and hope to keep it for 5 more years. Making the cost about $2000 a year.

I also check with insurance companies to see if it has a high propensity for theft making the insurance higher. Another factor in deciding on vehicles is the property tax issue and how fast the car depreciates.

Guest's picture
Guest

I came to this post via lifehacker and post this reply there.

Wise bread? Home spun nonsense more like.
If putting 20% down makes for sooner payoff then why not put down more? Repaying over 4 years reduces interest? Then pay over 3. What role for the rate of interest? Not important? Payments less than 10% of disposable income in case of surprise bills or redundancy. Then why not 5%? Costly comprehensive insurance? in the UK it has long been the case that fully comp is often cheaper than lesser cover. Pennypinchers tend to cut other corners too apparently.
My rules of thumb for car ownership: Pay cash, if you've got it, if you haven't think again whether you need a car at all. If you must then, match the rate of repayment to the rate of depreciation. Pay off a fast depreciater quicker than a slow; you never want to be in negative equity. If you lose your job you can sell the car.
Never take dealer finance, especially leases. Get a personal loan in advance; if you have to sell the car early you won't have to be obliged to pay early settlement fees. But more importantly, presentinmg yourself as a cash buyer gives you power to haggle. Use it. Use it hard. The biggest expense in motoring is depreciation. Almost all initial depreciation is the dealer mark up. The more you haggle the lower depreciation. So if you do nothing else, HAGGLE.

Guest's picture

You'd be MUCH better served to pay yourself a car payment and drive your current car as long as it's viable. When you have the cash along with resale of your current car, upgrade. Refuse to chase bigger and better to compete with the Joneses. You can afford a car when you can pay for it, not when you can afford the payments. Payments is proof that you cannot afford it.

Guest's picture

The other thing - you need to drive car you like. Believe you me you will not get the same adrenalin driving bmw when you are in your 20-ties then in your 40-ties.

If it is something you like - spend money on it. Will force you to make harder and feel better. Life out there is for joy, as well as saving money :-)

Guest's picture
Gueste

How about buying gently used rather than new? Why spend an extra 10K or so for the sticker shock when often you can get almost the same car for much less?

Guest's picture
Josh

What I did was took my car loan out for as long as they would let me, yes I sacrificed a little interest rate to do so. I asked the credit union to calculate my payments for 48 months, I then took the loan out for 72 months. I make the 48 month payment each month so that I am ahead, and if any emergency comes along I can cut my payment back to the agreed upon 72 month loan, freeing up some cash if I'm in a pinch, this way not only am I ahead of the game, but I can stay ahead if my emergency lasts an extended period of time....ex: 48mon=$400 vs 72mon $250...withing the first 6-8 months if you pay 400 you'll be ahead about 3 months worth of payments, if something happens you cut the extra 150 you are paying and pay the $250, but you have 3 months before you have to make a payment, saving 750 bucks, yes you will pay more interest but at least this plan leaves you options.

Guest's picture
Josh

This is really great advice. Wish someone had told me about the 20/4/10 rule before I bought my first "adult" car. Also, Good job reminding people of car insurance. Seems it's usually an afterthought and, depending on the type of car you buy, it can drastically change the cost of the vehicle over its lifetime. Definitely something to watch if you are buying on a budget.