If you don't have a clear picture of how much you can actually afford, it's all too easy to bite off more than you can chew getting behind the wheel of a new car. Many people fall in love with a dream car and enter a state of denial when it comes to the math. Or they let themselves be lulled by a friendly salesperson into buying more options than they need or extra-cost items they can do without, like an extended warranty service contract.
Affordability, of course, means different things to different people, and usually hinges on both household income and existing obligations.
At the same time, this is a good opportunity to shop around for money. Interest rates are still lower than they were 10 years ago, and lenders have loosened up their credit requirements in the past two or three years.
Below, we provide insights and strategies for getting the most car for your money. We'll tell you how to estimate what you can afford, and how and where to shop for the most favorable loan rates.
What's Your Budget?
Take an honest look at your current finances. The fancy word for this is doing a "cash flow analysis," but it's really just a monthly budget. See how much you currently spend on essentials like mortgage or rent, utilities, food, and clothing. Add other monthly payments, such as student loans, homeowners insurance, cell phone, internet, and cable TV. Don't forget to include local taxes, if any, not deducted from your paycheck. It's important to leave yourself a decent cushion for entertainment, vacations, emergencies, and retirement savings.
Now look over your bank and credit card statements for the last two years. This should give you a solid idea of where all the money goes. You may find places where you can cut back, or you may already be running pretty lean.
Years ago there was a common rule of thumb called the 20/4/10 rule that was used to estimate auto-ownership affordability. That means making a 20 percent down payment, taking out a four-year loan, and devoting no more than 10 percent of your gross income each year to the loan, including car insurance.
In current times that guidance just doesn't work for people. New-car prices are too high for a three- or four-year loan, and incomes are stretched too thin. As a result, car buyers are taking out longer and longer loans to keep the monthly payment bearable. The average term is now 68 months (5 1⁄2 years), according to Experian Automotive, the market-analysis arm of the Experian credit-reporting agency. Scary fact: 28 percent of all new loans run from about six to seven years.
Super-long loans are not a great idea, even if it seems a lot of people are doing it. Unless you can come up with a really large down payment, you will owe more than the car is worth for many years to come. Lenders call the period where you owe more than the car's value "being upside down."
If you have to sell the car or if it gets totaled before you reach the break-even point, you'll wind up making continuing payments on a car you no longer own. The extra years of payments also mean extra years of interest, and that can really add up.
Many people trade in a car they still owe money on. A dealer who arranges financing then rolls whatever is due on the old loan into the new loan. This may look like an attractive proposition if you can't pay off your old car before selling it.
But beware. In essence you'll be paying off the balance due on the old car for the entire term of the new loan. And that balance due will be affected by whatever the dealer offers as a trade-in allowance. If the dealer gives you a lowball trade-in allowance, you could be upside down for a long time.
Price Your New Car Insurance
Your cash-flow analysis will tell you how much you have left over to devote to car ownership each month. Your monthly loan payment has to be considerably less than that so that you can also cover costs such as fuel, maintenance, and insurance.
Once you have a candidate car in mind and know its approximate price, call your insurance agent to ask what it would cost to add it to your policy.
If you've been driving an old car up to now, you might be surprised at how much your rates may rise. Obviously it costs more to insure a car valued at $30,000 than one valued at $10,000. Though you might have dropped collision coverage on your old car to save money, you'll want that coverage on the new one. Plus, it's also required by the financing company if you have a loan or a lease on the vehicle.
Your Monthly Payment
As far as car selection is concerned, the point of the budgeting exercise is to determine the highest monthly payment you are comfortable with. That is information you keep to yourself when negotiating with a car salesman, however.
Why keep that information close to the vest? Because the moment a car salesman discovers the highest monthly payment you can bear is the moment he can structure a deal that will use every bit of it, and possibly put you into the most expensive car he can. The easiest way for him to do that is to stretch out the loan. That also gives a dealer who arranges financing the ability to build in a higher than necessary interest rate without you realizing it.
Making a sober assessment of what you can comfortably afford might tell you that you shouldn't buy the car you had your heart set on right now. Then you might either consider a cheaper car (perhaps even a comparable used car) or postpone the purchase until you can save up a larger down payment. Another option is leasing.
Test-Driving Monthly Payments
How much car will a given monthly payment buy? Numerous online loan calculators can help you do the math. One that's especially easy to use is the "affordability calculator" at Cars.com, but there are many others. Among other things, they let you plug in a monthly payment of your choice, along with other assumptions, and see the total price of the car that payment will finance.
How Much Car for a Monthly Payment?
When you're buying a car, the dealer will often try to get you to fixate on how much you can afford in monthly payments. He'll then structure the deal to give you the most car for the lowest monthly payment. Sounds great, right? It isn't. Sure, the longer the loan, the less you'll pay each month. But you'll actually end up paying more for the car in the long run, because you'll be paying more in interest payments. This table calculates how much you will have to pay each month for a vehicle, assuming an annual interest rate of 3.5 percent. Buyers paying off their vehicle in four years pay 6.8 percent of payments in interest. Those taking five years have 8.4 percent of their payments going to interest. And those taking six years have a whopping 10 percent of payments going to interest.