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How Much Car Can I Afford?

A car purchase can be a significant investment. Overspending in this area may cause undue stress and pressure on your finances. If you want to avoid that, there’s one question you need to ask yourself before buying a car: “How much car can I afford?”

Most people who buy a car choose to finance their purchase; here are some tips that will help you set a reasonable budget when financing your car.

How Much Should You Spend on Your Next Car?

Experts recommend spending no more than 15% of your take-home pay on your car-loan payment each month. What’s take-home pay, exactly? It’s the amount you have left over after taxes (local, state, and federal) and benefits (medical insurance, retirement plan contributions, etc.) have been deducted from your gross income.

For example, If your take-home pay comes out to $3,000 each month, 15% of that is $450. Based on the guidance we’ve discussed, $450 is the most you should spend on your monthly car payment.

Create a Budget

It’s helpful to take a closer, more detailed look at your finances when planning a car purchase. To create a specific budget for your new car, follow these steps:

1. Calculate your take-home pay

Your take-home pay represents the portion of your salary available for you to spend each month. As mentioned above, calculate this figure by subtracting the total amount paid in taxes and benefits from your gross income (or just adding up all your paychecks or direct deposits over the course of a month).

Your next step is to determine how much you spend on monthly expenses unrelated to car ownership. Some typical monthly expenses you should keep in mind include the following:

  • Mortgage/rent
  • Credit-card debt
  • Groceries
  • Clothes
  • Utilities (internet, electricity, gas, etc.)
  • Entertainment (movies, golf, etc.)

Calculate the total amount you spend on all expenses similar to the ones listed above.

Now look at monthly expenses directly related to a vehicle’s cost of ownership. If you don’t own a car, estimate how much each will cost. Here are some key car-related expenses to consider:

  • Insurance
  • Fuel
  • Registration (usually paid annually, not monthly)
  • Maintenance and repair
  • Parking

Add up all the expenses listed above.

4. Calculate how much you have for your monthly car payment

Add your total car-related expenses to your non-car-related total expenditures to calculate this figure. This figure is your overall monthly expenses.

Next, subtract that number from your take-home pay. This will leave you with a figure representing the amount of free cash you could theoretically dedicate to your monthly car payment.

For example, say your take-home pay is $3,000 monthly, and your overall monthly expenses total $2,100. If you subtract $2,100 from $3,000, that leaves you up to $900 to spend on your monthly car payment.

Remember that you may want to spend money on items other than the previously discussed expenses. Maybe you want to save money each month to dedicate toward a home remodel or a vacation, or perhaps you want to build up a rainy-day fund for those inevitable unforeseen expenses. Remember when deciding how much to spend each month on a car payment.

Considering both planned and unplanned expenses, it’s wise to keep your car payment at no more than 15% of your take-home pay — or $450 a month based on our hypothetical $3,000 take-home pay.

Photo Credit: Getty / NicoElNino
Your credit score will have the biggest impact on your interest rate. / Photo credit: NicoElNino, Getty Images

5. Determine the total car loan amount you can afford

Now that you know how much you can spend each month on your car loan, you can figure out the total loan amount you can afford. Your entire car loan amount will depend on these variables:

  • Loan term: This is the length of your loan or the number of monthly payments you’ll need to make to pay it off in full.
  • Loan APR: This is the annual interest rate for your loan, and it will depend mainly on your credit score. Interest rates vary from lender to lender, so shopping around can help you get the best rate.
  • How much you spend: Used cars typically cost less than comparable new cars. If you buy used, you’ll likely need to take out a smaller loan than you would if you were buying a similar new vehicle. That said, loans on used cars tend to have higher APRs than loans on new cars.

6. Establish a purchase price

Remember that your purchase price may differ significantly from your loan amount. If you’re trading in a car, the value of your trade-in will count toward your purchase and reduce the loan amount. Also, any money you’ve set aside for a down payment on your purchase will reduce the money you’ll have to borrow.

Remember that it’s important to include the extra expenses associated with a vehicle purchase when calculating your purchase price. These include destination charges, sales tax, and documentation fees. As a rule of thumb, expect to spend another 10% of the advertised sale price of your car to cover those charges. That means that if you’re buying a $30,000 car, you should plan on spending a total of $33,000 for your car purchase.

Here are a few examples of how your loan term impacts how high your purchase price can go, assuming a 5% interest rate and a budget of $450 per month:

  • With no down payment, a $450 monthly payment, and a 48-month loan term, your total comes to $19,500. Factoring in the extra 10% for expenses we discussed above, your new car’s price tag could be about $17,750.
  • With no down payment, a $450 monthly payment, and a 60-month loan term, your purchase price comes in at about $24,000, or a vehicle price of around $22,000.
  • With no down payment, a $450 monthly payment, and a 72-month loan term, your purchase price is $28,000, or about a $25,000 vehicle price.

Your interest rate will vary based on your credit history, loan term, and what you’re buying. Those with excellent credit pay the lowest rates, and rates on new cars tend to be lower than rates on used ones. Some lenders occasionally offer zero-interest car loans, but they’re reserved for those with excellent credit. Borrowers with poor credit may pay rates exceeding 14%.

Next Steps

If you have questions about this story, please contact us at Editors@carfax.com