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