How Much Car Can You Afford?

It can be difficult to figure out how much of a car you can afford. Everyone has variables in their incomes, budgets, and spending; two people making the same income will have different amounts they can spend at the dealership depending on factors like their financial obligations, variations in spending habits, or even where they live.

If you're dreaming about the release of the latest electric truck or wondering if you can afford a second or third car in your household, we've got three tools that'll help you figure out if this set of wheels is within your reach.

1. The 10 or 15 Percent Formula

According to some experts, a good rule of thumb is ensuring your car payment takes up no more than 10 to 15 percent of your monthly take-home pay. This would mean if you take home $5,000 a month after taxes and payroll deductions, you should aim for a car payment anywhere under $500 to $750 a month.

The drawback with this formula is that it asks you to make a decision on the affordability of a monthly car payment instead of making a decision based on the affordability of the actual car. You'll be negotiating on a monthly car payment instead of the total price of the car, which won't work to your financial benefit. Salespeople can do things like extend a loan length by several years to drop your monthly payment down so you can afford a car short-term, yes, but that decision will cost you hundreds, even thousands, of dollars of additional interest over time.

So here's a better way to use this rule: aim for a payment of no more than 10 to 15 percent of your take-home pay with a loan term of 60 months or less. You can use Hanscom FCU's car loan calculator to give you a solid idea of what kind of car you can afford using this rule. It's becoming more common in the auto industry to see loan terms of 72 and 84 months. In the short term that may sound appealing, especially if you're enamored of a certain car, but in the long term, it'll be a costly decision you may come to regret, especially if that long-term obligation puts you at the upper end of what you can afford each month.

2. The 20/4/10 Rule

Other experts advise new car buyers to follow the 20/4/10 rule. Here's how that rule breaks down:

20 percent of the purchase price is the least amount of money you put down on the vehicle
4 is the maximum number of years you should finance the vehicle
10 percent is the total you should spend on transportation costs out of your monthly income

If we look at someone with $3,000 in net monthly income, this would mean spending no more than $300 a month on not only a car payment, but also fuel, insurance, and maintenance. Using Hanscom FCU's car loan calculator, the current average price of a new car ($40,000), and the best possible rate for someone with excellent credit making a 20 percent down payment, the monthly payment on a 48-month term loan would be over $750. To bring a monthly payment under $300, it would require a down payment and/or trade totaling $29,000 ($284.05). This doesn't include fuel, insurance, and maintenance costs that, depending on the type of vehicle, can add hundreds of dollars a month to transportation costs.

To put these numbers in perspective, according to research from the Automobile Association of America (AAA), the average cost of vehicle ownership in 2020 was just over $9,500 a year, or roughly $792 a month. If we apply the 20/4/10 rule to this figure, it would indicate a net annual income of $95,040. Considering the median weekly earnings for full-time American workers in the second quarter of 2021 was $990 according to the Bureau of Labor Statistics, it suggests that for many consumers, the 20/4/10 rule may be unrealistic based on income, today's escalating car prices and transportation costs, or even what part of the U.S. one lives!

Rather than using 20/4/10 as a hard-and-fast rule, it may be better to use it as a guideline to see how a particular purchase would work for your budget and unique circumstances. For example, you may have a substantial down payment saved up and a trade-in, along with very little debt in a community with lower insurance rates, in which case you have more flexibility. Likewise, the "rule" may show you that with your income, debt obligations, and the fact that you live in an area of the country where gas prices and insurance rates are the highest, a particular make and model of a car will be a stretch for you and not the best financial decision you can make right now.

3. Your Own Affordability Analysis

Your own analysis of your income, debts, wants, and needs will give you the best answer to how much car can you afford. As we alluded to above, knowing your total income, how much you put away for savings and retirement, what debt obligations you have (mortgage, educational costs, credit cards, etc.), and what your spending habits look like can help you make a more informed decision about what you can afford.

Your first step is to get a handle on your income and expenses. If you keep a monthly budget, you're almost there. (If not, here's how to get started.) Then ask yourself:

Am I replacing a vehicle? If you're selling it or trading it in, this money you get for it may be used for a down payment. However, if you are "underwater" on the loan, you may owe more than what the car is worth, so you'll need to account for the deficit in your car purchase budget. You'll have to look at the maintenance and insurance costs, along with taxes and possibly higher fuel costs, on a new car vs. the one you're replacing. If you have a specific vehicle in mind that you would like to purchase, your insurance agent or company can give you an accurate idea of how much your policy will change.
Am I adding to my fleet? You may be adding an additional car payment to your budget. And even if your existing vehicles are paid off, you'll have an additional vehicle needing regular maintenance, insurance, and fuel. Can your budget handle it?
What do my future plans look like? A new job or paying off a large debt like a mortgage can make your budget look rosy. Likewise, if you know in the next couple years you're going to have some major tuition bills as an empty nester, it would be wise to take this into account in your decision making.
What does a car mean to me? Some people see their car as something that gets them back and forth to work every day, or hustles their kids to school, band practice, or other activities. It's a practical expense, one that they're happy to save as much money as they can with its purchase. Then there are others who get a kick out of owning a certain car and don't mind spending more each month to drive a vehicle that makes them happy. And of course, there's everything in between. There's no right or wrong answer here; it's just important to know where you stand and what you'd feel comfortable spending each month to get to work, schlepp the kids, or simply enjoy the ride.

As a Hanscom FCU member, you can be pre-approved for an auto loan. All you need to do is fill out a loan application^†, and you'll know exactly what you can afford. Any additional questions? Contact us today!

^†Note that submitting a loan application will result in a hard pull on your credit, which will temporarily reduce your credit score. Submitting a loan application does not obligate you to take the loan.

If you're in the market for a new vehicle, be sure to download Your Guide to Smart Auto Financing, a free eGuide from Hanscom FCU. You'll learn about the financing options available to you, and even one option that you may not have considered. Download the guide today!