You’re looking into buying a new vehicle and have your eye on the perfect one. Still, you might ask yourself, ‘How much can I afford? ‘ Before taking out any financing or stepping onto a dealership lot for a test drive, you’ll need to fully understand what your personal borrowing power is. In this article, we will assist you in figuring out what you’re eligible for so that you can steer clear of any loans you can’t afford.
Start with a budget
Driving is expensive. Gas, maintenance, insurance, and registration must be factored into the actual cost of owning and operating a car. So, how much can you realistically afford? If you’re a regular driver considering leasing, financing, or buying a new vehicle, this is a question you need to ask yourself before making any significant decisions.
Buying a car should start with a budget. It may be the least exciting part of the process; however, it will let you know how much you can afford. It will also determine whether to buy new or used and how you’ll pay for it. It’s the starting point for making a difficult decision easier. The cost of buying and financing a car goes beyond the purchase price. In addition to your loan payments, you’ll need to factor in maintenance and operating costs, which we’ll discuss a little later.
To help you get a clear understanding of how much you can afford, you’ll need to look at both the cost of buying a car and all your current financial obligations. You should have plenty of money left over after all your current bills are paid to comfortably cover car payments.
What can you afford?
There are two schools of thought when calculating what a person can comfortably afford on any vehicle:
- Debt-to-income ratio or The 35% Rule
- The 20/4/10 Rule
1. Following the 35% Rule
The golden rule to buying a new vehicle is to never spend more than 35% of your gross annual income on a car. Whether you’re paying cash, leasing, or financing a car, your upper spending limit really shouldn’t be a penny more than 36% of your gross annual income.
For example, if you make $36,000 a year, the car price shouldn’t exceed $12,600. If you make $60,000, the car price should fall below $21,000.
Now, 36% is an upper spending limit. Not everyone should spend over a third of their income on a car. Folks who want something to transport them to and from work will be pleased to spend way less.
Spending tiers: Which tier do you fall into?
There are three basic tiers that car buyers fall into when evaluating what they want to spend on a vehicle:
- The Frugal Commuter: “I just need something to get from A to B.” Spend limit: 15%
- The Compromiser: “I’d like some creature comforts — maybe a good sound system and heated seats.” Spend limit: 25%
- The Enthusiast: “I love cars and want my ride to be as fun/luxurious as possible within budget.” Spend limit: 35%
Remember, utilizing ‘The 36% Rule’ is beneficial because:
- You can still get top-rated crossovers, sports cars, etc., for under $15,000.
- You won’t run the risk of biting off more than you can chew in terms of monthly expenses.
- You’ll be able to invest all the money you save, enabling you to achieve financial independence much faster (and one day even buy a much nicer car!)
2. The 20/4/10 Rule
If you’re budgeting for buying a new vehicle, the rule of thumb is the 20/4/10 ratio, according to money and car experts alike. This rule states that you should:
- Put down a 20% deposit
- Obtain a loan term no longer than four years
- Keep monthly car payments (including principal, interest, insurance, gas and other operating costs) at or below 10% of your monthly pre-tax income
Your down payment should be at least 20% of the purchase price
As soon as you drive a car off the lot after purchasing it, you begin incurring depreciation. This is why a down payment of around 20% is recommended. If you put in less, you could end up paying more than the car is worth by the end of the year. By making a down payment, you’ll reduce the risk of incurring negative equity, which is when you owe more against the car than what it’s worth. A lower monthly payment makes affording gas, maintenance, and auto insurance a little easier on the pocketbook.
Limit your car loans to 4 years or less
Car loan terms usually range from two to seven years. The longer your term, the more interest you’ll pay. Financial experts agree that a car loan’s duration should be 48 months – or, if you can afford it, go to 36 months. Never stretch the loan past 60 months. If you can’t make the payments work within these timeframes, you should probably be looking at a less expensive car. By shortening the term, you’ll reduce financing costs. In addition, longer loan terms can hurt your car insurance costs.
Monthly payments should be less than 10-15% of your take-home pay (after taxes)
All costs of car ownership should be 10% of your pre-tax monthly income, or less. A $50,000 salary results in $36,662 in take-home pay. If we calculate 15% of that take-home pay, we arrive at $5,499.30, or car payments of $458.28 per month.
To calculate your income after taxes in Ontario, please click here.
Additional car expenses
In addition to the purchase price of your vehicle, there are various other expenses to factor into your budget, including the following:
- Fees: Car registration fees, sales tax, dealer fees, freight fees, pre-purchase inspection fees, and so forth.
- Add-ons: Starting price is for the base model with no additional features. If you choose to add additional features that are not included in the base price, you’ll need to pay extra for each one.
- Warranty: New car purchases typically include a basic factory warranty that covers nearly all components of the vehicle, except wear-and-tear items. This includes filters, brake pads, and tires, among other components. But if you want an extended warranty, you’ll need to pay for it.
- Fuel: Estimate how far you drive each month and how often you refuel to estimate your monthly fuel costs.
- Repair and maintenance: Cars need regular maintenance to keep them running smoothly and safely. That includes paying for services such as oil changes, car washes, tire rotations, and more.
Buying a New Vehicle: The Bottom Line
Cars come in all shapes and sizes. Whatever car or truck you’re looking to buy, remember that you should begin your investigation by asking yourself ‘how much can I afford?’ It is crucial to gather all the facts to ensure you can not only afford the car loan payments but also cover any potential repairs and maintenance costs down the road. Owning a new or used vehicle should enhance your life and allow for unlimited possibilities. However, if your dream car becomes an added burden, you may need to recalculate or consider a different option. We hope this article helps guide you if you’re considering a new vehicle.
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