How Much Car Can You Afford? Understanding the Numbers

Explanation of Terms

Monthly Payment: When deciding how much of a monthly car payment you can afford, you’ll want to consider your take-home pay—which is the amount you make each month after taxes and other payroll deductions. Ideally, your monthly car payment shouldn’t be more than 10% to 15% of your take-home pay. 

Down Payment: The down payment is the amount you pay up-front for the car. Typically, a larger down payment will mean lower interest rates and reduced monthly payments, which can significantly reduce the overall cost of the car.

Loan Term: A loan term is the amount of time until your car loan is paid off. Longer terms allow for smaller monthly payments, but they often come with higher interest rates that increase the total amount you end up paying for the car.

Interest Rate: A car loan’s interest rate depends on a few factors. Generally, buyers with high credit scores, large down payments and short term lengths will be eligible for the lowest interest rates.

Video

3 rules for financing a car

If you’ve established that financing is the right move for you, what are your next steps? What are some good rules of thumb to follow to ensure you get the best deal from your auto loan? 

Put at least 20% down

The key objective of any loan is this: Don’t go upside down.

You’re “upside down” on a loan when you owe your lender more than the asset is worth — meaning that even if you sell it, you still owe money on something you don’t even have anymore!

Yeah, upside down is not a fun place to be. 

That’s why you’ll often see the number 20% thrown around when it comes to a car loan, a mortgage, etc. Large down payments not only help to reduce your monthly payments, and serve as a good litmus test as to whether you can afford the car — they also erect a dam to prevent you from going underwater. 

Pick a loan term shorter than 48 months

It might be tempting to push out your car loan term on the Car Affordability Calculator to lower your monthly payments. After all, in our earlier example, if we extend the term from 48 to 72 months, the monthly payment drops to just $175.23. 

But pushing out your loan term means you pay much

But pushing out your loan term means you pay much more in total

To illustrate:

  • 48 months X $252.89 monthly payment = $12,138.72.
  • 72 months X $175.23 monthly payment = $12,616.56.

That’s almost $500 more just in interest. Plus, that’s two more years you might have to pay a lender’s higher insurance requirements. Lastly, you don’t want to still be paying off your car as its value plummets after four years, since the risk of going underwater goes higher. 

Your total car monthly payment (interest, principal, sales tax, and insurance) should not exceed 10% of your gross monthly income

This is sort of a more granular version of the 35% rule. 

The 35% (or less) rule gives you a general budget to plug into the search filters on Carmax, Edmunds, etc.

But when it comes down to brass tacks, you’ll want to zero in on the monthly payment. Take your annual income, divide it by 120, and that’s the most you’ll want to pay for a car each month including insurance. 

Read more: Tips for saving on your car loan

Consider Your Purchasing Options

If you’re on a tight budget, explore all of your options before purchasing a car. Several choices are available, including leasing or buying a used or new car.

Leasing

A car lease allows you to essentially rent a car from a dealership for a certain length of time and mileage. It can be a good option since the monthly payments are lower than those for buying the car outright. However, keep in mind that you’ll have a mileage limit and the money you pay toward your car won’t bring any value to you.

Buying a Used Car

Purchasing a used car gives you more freedom than a car lease. Used cars tend to be priced significantly lower than new cars, making monthly payments more affordable. Additionally, car expenses such as insurance tend to be lower for used vehicles.

Buying a New Car

If you want to purchase a new vehicle, do your research so you know which make and model you want. Knowing a car’s fair market value will help you negotiate the best deal possible at a dealership.

How to use our car affordability calculator?

Are you curious how much you can spend on a car? Try our car affordability calculator and find out. Using the calculator is simpler then you think.

All you need to do is to provide some basic information:

  • Monthly payment you can afford is a maximum amount you can spend on a car loan each month. When establishing this value remember the rule of one third, which we presented in the previous section.
  • Money you have is money you have and can spend on a car (it can either be cash or the money on your bank account).
  • Current car trade-in value is a value of your current car (only if you have one, obviously).
  • Interest rate is the cost of a car loan (in our calculator it should be provided on a yearly basis – APY.
  • Loan term is the term of your car loan. We suggest it to be no longer than 48 months.
  • Sales tax is the car sales tax rate. It is different in each state (this field is available in advanced mode).

After you fill in the last field, our car affordability calculator will immediately show you your results. The most interesting value is the maximum car value. It informs you what the upper limit of value is that you can afford to spend on a new car.

The car loan affordability calculator will also estimate the loan amount which is calculated on the basis of the monthly payment you can afford. Moreover, it will also compute the total sum of interest paid and the total value of sales tax (in the advanced mode).

Shorter Term Loans Have One More Advantage…

They can keep you from being “up-side-down”. This term refers to owing more on your car than the equity in it. When you make a payment, part of your money goes to interest and part to principal. In the beginning of the loan, most of the money is placed on interest. With long term loans it takes a much longer time for more of your money to be placed on principal, therefore delaying the amount of equity you build. If you decide to sell your car, you may owe more on it than the equity in it, thus being “up-side-down”. Putting down a larger down payment can help to avoid this situation.

Summary

The golden rule to car buying is to never spend more than 35% of your gross annual income on a car. 

Now, your reaction may be eh, I was hoping I could spend more…but remember: There are a lot of used cars you can still get within your budget, and all the money you don’t spend can be invested and multiplied. 

If you’re smart and frugal with your money, the Mazda you buy today can become the new Mercedes you drive tomorrow.

Read more:

Tags