You’re looking into buying a new vehicle and have your eye on the perfect one, but you might ask yourself, ‘How much can I afford’? Before taking out any kind of 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 all need to be factored in when it comes to calculating the true cost of owning and operating a car. So, how much can you realistically afford? If you’re a regular driver and are thinking of leasing, financing, or buying a new vehicle, this is a question you need to ask yourself before making any big 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 to help make a difficult decision easier. The cost of buying and financing a car involves more than just the ticket price. In addition to your loan payments, you’ll need to factor in maintenance and operating costs which we will get into 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. Make $60,000, and 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 just want something to transport them to and from work will be perfectly happy spending way less.
Spending tiers: Which tier do you fall into?
According to Moneyunder30.com, 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 lose money to depreciation. This is why a down payment of around 20% is recommended. If you decide to put any less, you can be paying more than what 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 anywhere 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 the costs of financing. In addition, longer loan terms can have a negative impact on 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 means you take home $36,662. If we calculate 15% of that take-home pay, we end up 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 come with a basic factory warranty, which covers just about everything on the vehicle except wear and tear items. This includes filters, brake pads and tires, among others. But if you want an extended warranty, you’ll need to pay for it.
- Fuel: Estimate roughly how far you drive every month and how often you have to fill the gas tank to get an idea of how much you can expect to pay to fuel up each month.
- Repair and maintenance: Cars need regular maintenance to keep them running smoothly and safely. That includes paying for services like oil changes, car washes, tire rotations, and so forth.
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 important to gather all the facts to ensure you can not only afford the car loan payments, but any potential repairs and maintenance requirements down the road. Owning a new or used vehicle should enhance your life and allow for unlimited possibility. However, if your dream car ends up being an added burden, you may need to redo your calculations or look into a different car option. We hope this article helps guide you if you’re thinking of buying a new vehicle.