Whether you’re just starting out with your first car purchase or thinking about upgrading the old family car, make sure you understand what you are actually getting yourself into. Transportation is often the second-largest monthly expense for families, after rent/mortgage. That means that after paying for shelter, most households spend more on transportation costs than taxes, utilities, or food, those transportation costs are usually made up mostly of car payments. So before you decide on what car you’re going to buy next, ask yourself “how much car can I afford?”
Pay Cash
The easiest way to ensure you can actually afford your car is to pay for it in cash! Save up as much as you can and whatever you have saved when it comes time to buy a car, that’s your budget! Simple as that! “But I’m just starting out, I only have a few hundred dollars saved.” Guess what, that’s your car budget unless you put off buying a car for a while more to continue saving. Get a reliable car that can get you from A-B and continue saving up for something better.
When you get a decent amount saved, trade-in your first car and make the trade-in an addition to your savings budget. Continue doing this for a few years and eventually, you will be able to afford a car you really want.
But if, for some reason, you insist on buying a better car than you can currently pay cash for, maybe you live in the boonies, have a bunch of kids who need to go 3 different ways every day, or your job requires you to drive for hours a day doing sales calls and you need to get a car right now, make sure you get a car payment you can actually afford.
Car Payments Should Be No More Than 5% of Your Income
In order to keep your car payments manageable, they should never equal more than 5% of your pretax income. This should ensure that you have plenty of money left over for your other monthly expenses and saving for your future. Your car payments should never take over your life or hold you back from your future ambitions.
Examples:
If someone makes $100,000 a year / 12 months = $8,333 income per month (pre-tax)
$8,333 x 5% = $416
Their car payment should be no more than $416 a month
If someone makes $50,000 a year / 12 month = $4,166
$4,166 x 5% = $250
This person’s car payment should be no more than $250
For many people, these are incredibly low numbers! “You can’t afford to get anything nice with those numbers!” you might argue. That’s true! Nobody NEEDS an $80,000 Escalade! Cars like that are a WANT, and if you can’t afford it, you shouldn’t WANT it.
When you are just starting out in your career, you should not be going out and purchasing the biggest and best car possible. You should purchase a nice used car that is reliable and within your budget. Save as much as possible and invest it to create a more comfortable lifestyle in the future.
If you are further along in your career, you should have a higher income and hopefully you’ve saved up a larger down payment. If not, past car payments could very well be holding you back. Even more, reason to get a nice, reliable used car within your budget, so that you can begin growing your investment dollars.
Remember, these are car payments, trade-ins and down payments help you bring these down. If you’ve saved up a good chunk of money and just need a little bit more because your last car straight up died on you before you fully funded your car fund, you should easily meet these numbers.
Car Payments Should Never Last For Longer Than 3 Years
Now, many people may think “cool, I can get a car with an “affordable” monthly payment, I’ll just push the loan out to 6 years.” NO! Don’t do it! That’s not going to help you, it will just make things worse. Not only will it lock you into a payment for 6 years, but in those 6 years, any number of things can happen.
- Cars depreciate fast! The average car loses between 15-20% of its value each year according to bankrate.com. So within 5 years, that brand new car has the potential to lose about 75%+ of its value. If you bought a $40,000 car 5 years ago, it could now be worth only $10,000 in resale value, while you’re still paying on a $40,000 loan.
- You could get in an accident! So you’ve gotten a nice new $40,000 car and driven it around for a year or so, then BAM, you get rear ended at a red light. Now your car’s value is maybe around $32,000 (pre-accident) but due to interest, your loan is still over $35,000. Your insurance company totals it and hopefully gives you a check for $32,000. Guess what, your insurance check doesn’t cover your loan payment. You’re still liable for $3,000. Now you have no car, no money to buy a new car, and you still owe $3,000 to the bank for a car you can’t even drive. Not a situation you want to be in.
- You might NEED to sell your car! Maybe you suddenly lose your job or your financial situation changes and you can no longer afford your car payment. If your car has been depreciating faster than your loan balance has been paid (often the case in loans longer than 3 years) you could be stuck in a similar situation to the accident example. You sell your car but market value is less than what you owe on the loan so you’re stuck holding the balance and no car.
Make sure you can afford your car payments on a loan of 3 years or less.
Invest the Difference between “Technically” Affording and Actually Affording
Do you have a dream car in mind? You just got a promotion at work and could “technically” afford the car payments on that dream car, so long as you scrimp and save in other areas, never have an emergency, and never unexpectedly lose your job. It’s only a little bit over 5%, maybe closer to 10-15%, of your new income.
How about this, instead of “technically” affording that dream car now, why not get a car you can actually afford and invest the difference? In a few years, you will not only have been driving a car you can afford, but you will also have a nice pile of money growing in the background. You can then continue to grow that money or use it to buy your dream car for cash without a worry in the world and a huge sense of accomplishment. You may even realize that you like watching that pile of money grow more than you want the dream car. But now the choice is yours to make, no loan payments necessary.
Luxury Cars Should Always Be Paid For In Cash
Taking out a loan for a car you actually NEED is one thing, but taking out a loan for an excessively expensive luxury car (that will probably have high insurance and maintenance costs as well) is unacceptable. If you want an expensive luxury car, you better darn well be able to walk in and pay cash for it. If you can’t, don’t even think about it right now. Build it up as a wonderful future dream that you will work your tail off for. Then actually work your tail off for it.
If you’ve worked hard, saved hard, and invested smartly to have the money to slap down cash and still have a hefty balance of growing investments, then go ahead and buy that dream car. You’ve earned it!
But no cash, no luxury car, ok? Get it out of your head because it will only screw you up financially.
Wrap Up
So please, before buying your next car, please ask yourself “how much car can I actually afford?” It may be by paying cash or by taking out a 36-month loan for less than 5% of your income. Either way, make sure that your car purchase is not going to harm you financially, today, or in the future.
And if you’re already stuck in a car you can’t afford, either sell it (so long it’s worth at least as much as the loan balance, check out Kelley Blue Book) and get something more affordable or start tacking on extra to the payments every month. If your monthly payment is $500, throw on an extra $100, $200, or however much you can, towards the principle to get it paid off ASAP.
Years ago, we made the mistake of buying our 1st car after a big promotion with a 7-year loan to keep payments “affordable” and then saw how much interest we were paying every month, we put a huge effort into paying it off ASAP. The bank lender thought Mr. Bean was talking crazy when he walked into the bank and asked to put an extra $1,300 on top of the payment every month, she even confirmed with him twice before finally processing the change. But we had it paid off within 5 months after that. If you can, go make a bank lender lose their mind. It’s fun! 🙂
Side note: If you are looking to sell your current car, check out this article from SavingAdvice.com on Why Dealerships are Paying Top Dollar for Used Cars. You just might get more for your car than you were expecting.
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