If you’ve been scrutinizing your budget lately, and considering ways to save money, your monthly car payment is probably an expense you’d be happy to shrink. Fortunately, there are options available to drivers seeking to rein in the cost of car ownership without letting go of their ride. Loan modification is one approach to a…
No pressure: Buying a car is one of the biggest purchases you’ll ever make.
You’ve heard people say that cars represent freedom, right? Well, that’s only partially true.
In reality, if you spend too much on a car purchase, you might not be able to afford to go anywhere at all. And if you can’t still afford to meet your other financial goals, like saving for retirement, you could end up paying for far more than you bargained for down the line.
That’s why asking the question “how much car can I afford?” is so important. Rather than just picking a number at random and heading to the dealership, deciding how much you can afford before you start shopping is wise. You’ll make sure to get the car you need at a price you can afford, so you don’t have to worry about any other headaches in the future.
Common Rules of Thumb
There isn’t any one set rule for how much car you can afford. Rather, it depends on your personal financial situation and your comfort level.
Still, some financial gurus have come up with rough rules of thumb. It can help to take a look at some of them, but be warned: They’re quite scattershot. We’ll also provide a better, more guided approach down below.
50% of Your Income Across All Vehicles
Coming in with the largest rule of thumb is debt-freedom guru Dave Ramsey, surprisingly. Ramsey recommends that all of your vehicles combined should be worth no more than 50% of your take-home pay.
For a household earning $50,000, that means that all the vehicles combined shouldn’t be worth more than $25,000. Similarly, if your family earns $100,000 per year total, the value of all of your vehicles shouldn’t be worth more than $50,000.
36% Debt-to-Income Ratio
Have you heard of the idea of a “debt-to-income ratio?” It’s simply a ratio between how much money total you owe, versus how much you make. So if you have $30,000 total worth of debt and your take-home pay is $60,000, your debt-to-income ratio is 50%.
Many experts use a maximum debt-to-income ratio of 36% as a rough rule of thumb. That’s only a suggestion, however. Many lenders approve car loans (and refinance loans) with a DTI around 50%.
To find out how much car you can afford with this 36% rule, simply multiply your family’s income by 0.36. So if you earn $100,000, for example, you could afford to take out a car loan of up to $36,000 — assuming you don’t have any other debt.
(DTI) Debt-to-Income Ratio Calculator
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10% of Income
The 36% DTI rule is a good one to limit yourself by. But if you can get your car payment even lower, so much the better. In fact, some experts even say to keep your total car cost — including your other car ownership expenses — to just 10% of your income.
For our example $100,000 family, that means you shouldn’t spend more than $10,000 per year total on car costs. This one gets a little trickier because it includes all your other expenses too, on top of your auto loan. It might be a lot lower than you will want to go. But if you can do it, you’ll have a lot of money left over for other things that are important to you.
A Good Step-By-Step Approach
These rules of thumb are helpful to guide your thinking about how much new vehicle to buy. But it’s always best to look at your own numbers. After all, your financial situation is probably very different from everyone else’s. Here is one way you can determine how much car to buy.
Step 1: Figure out How Much Total You Can Afford to Spend on Your Car
The first step is to look at your budget. If you don’t keep up with one regularly, don’t worry! You’re not alone. Most Americans don’t budget.
Instead, at the very least, you can make a list of your monthly take-home pay and expenses each month. That’s all a budget really is, anyway.
Pro tip: Remember to include things you don’t pay every month, like insurance or registration. If you only pay a bill every so often — such as once every six or 12 months — just divide the total by six or 12. For example, if your renter’s insurance costs $600 every 12 months, you’ll need to set aside $50 per month for it. If you need to jog your memory, you can look back over old bank statements.
Once you’re done with the list, take a look at your budget. How much extra do you have left over after paying for everything you need, not counting car-related expenses? If you don’t have anything, you’ll need to find things to cut, or find ways to earn more money. In any case, decide on how much total you can afford on a car.
Step 2: Figure Out How Much Ongoing Maintenance and Fees Will Cost You
Buying a car isn’t much use if you can’t afford to maintain it. A lot of people focus on just the sticker price of the car, the down payment, or the monthly payment. But if you want to be able to drive it anywhere (legally, that is), you’ll also need to be able to pay for extras.
Estimate and tally up your monthly costs of the following things:
- Auto insurance
The cost of some of these things will vary depending on what car you actually buy. For example, your insurance cost could be very different depending on whether you choose an old, reliable car versus an expensive car like a Tesla. Still, do your best to estimate these costs. You can adjust them later.
Do you have any money left after paying for your car ownership costs each month? If so, then congrats — this is the maximum amount you can spend on your monthly car payment. If not, then you’ll need to cut costs further, so you can still afford to drive your car after you buy it. You can also save money in a lot of other ways, whether that’s by having a large cash down payment so that your loan amount is smaller, bringing in a trade-in, comparison shopping, taking out a lower-cost loan from a credit union, and avoiding sneaky dealer tricks.
Step 3: Figure out What Type of Loan Would Fit Your Budget
Now that you know how much you can actually afford to spend each month on loan payments, you can figure out the car price. Using a car affordability calculator can help you decide on your loan options to make sure the monthly payments fit in your budget. You can play around with the following variables to see what car price will fit for a given payment based on your interest rate and term length.
For example, if you know you can afford a $200 monthly car payment after meeting all of your other car-related expenses, you can use the calculator to see how much car you can afford based on a 36-month, 48-month, and 60-month loan.
Remember, the sticker price isn’t necessarily the loan amount. How much money you need to borrow (i.e., the loan amount) will vary depending on how big of a down payment you put down, the sales tax, your current car’s trade-in value, and any fees.
Keep in mind that just because you can afford a set dollar value, doesn’t mean you should actually spend that much. Think of it as a maximum cap to use when you go out car shopping. Spending under that cap is always better because it will help you save money. If you make sure your credit score score is good so that you can get the best interest rates, you’ll also save cash.
Finally, choosing the shortest-term loan you can will also help you get out of debt sooner, and save you interest payments over the long run too.
A Quick Example
Confused? No worries. We’ll walk you through an example using this step-by-step approach.
Let’s say you want to buy a car. After looking at your monthly budget, maybe you see that your expenses are $2,000 per month. If you have a monthly income of $3,000, you can afford to spend up to $1,000 towards your car. Less is better, but this is the maximum you can spend.
Let’s say you crunch the numbers, and come up with these car-related expenses:
- Gas: $55
- License: $9
- Parking: $25
- Repairs: $100
- Car insurance: $65
- Registration fees: $6
It would cost you about $260 per month extra in order to be able to use your car. Since you can afford up to $1,000 total towards your car, and keeping that car running will cost $260, you can afford a monthly payment of up to $740 — quite a large amount!
Maybe you decide you don’t want to spend more than $400 on a monthly loan payment. So, you enter your information into the loan calculator and play around with different loan term lengths. You’ll see that you can buy a car worth different amounts, based on how long of a loan you get:
- 36-month loan: $18,446
- 48-month loan: $22,541
- 60-month loan: $26,455
Maybe you decide you don’t want to be in debt for five years, even though you’d be able to buy $8,000 more car than if you opt for a three-year loan. Instead, maybe you’d prefer to pay off your car loan faster and be out of debt three years from now. So, you can confidently head out car shopping with a firm maximum price range in mind: $18,446.
What Are People Actually Spending on Cars?
We’ve given you a lot of options for how to choose how much to decide on a purchase price for a car. But what are people actually doing?
According to the U.S. Census Bureau’s American Community Survey, the median household income was $61,937 in 2018, the latest available data. If using any of the three rules of thumb above, here is the maximium you would theoretically spend:
- Dave Ramsey’s 50% rule: $61,937 / 2 = $30,968.50
- 36% DTI rule: $61,937 x 0.36 =$22,297.32
- 10% rule: $61,937 x 0.10 = $6,193.70
These figures are for the total cost for all the cars in your household, not just one.
We can also see the costs of different types of car purchases cost thanks to a 2019 Experian survey, including:
- The average new car purchase was for $32,797.
- The average used car purchase (when bought at a dealership) was for $22,267.
- The average used car purchase (when bought from a private party) was for $18,058.
If you’re trying to keep your debt under control, it seems that the best type of car to buy is a used car from an independent party rather than a dealership.
Remember, though: personal finance is personal. No one aside from yourself (and maybe a financial advisor) can tell you what exactly you should or shouldn’t do. It all depends on your own situation.
Always Crunch the Numbers Before You Buy a Car
It’s easy to get caught up in the shopping experience, especially when you’re buying a new car. You might not want to take the time to see if it fits in your budget. Even if you do run the numbers, there’s a good chance you’ll want to buy something even nicer. After all, it’s just a few thousand more to get a slightly newer used car, or one with extra fancy options, right?
Instead, try to keep a level head when you’re out car buying. If you make sure that you’re making a fact-based decision, you’ll be sure to enjoy your car for years to come. And that’s the way it should be: you shouldn’t be beholden to your car payment. A car really should be your freedom.