A car is probably the first biggest purchase of your life and perhaps the second biggest in your lifetime. The biggest purchase being your house. So when you ask the question how much car can I afford, the purchase price of the car and the monthly installments are not the only factors that you need to consider. Gas, insurance, repairs & maintenance are big factors that will eat into your car budget. There is no magic formula to determine how much you can afford but there are several ways you can arrive at a decent estimate. Here are some factors you should think about.
Factors to think about before buying a car and deciding how much you can afford
Percentage of monthly income
Edmunds recommends spending no more than 20% of your after-tax monthly income on car related expenses. And yes, that includes your monthly car payment, gas, insurance, and repairs and maintenance. However, I think that you should try to keep it below 15% if you want to grow your wealth. For example, if your after-tax monthly income is $4,000, make sure your car-related expenses are no more than $600.
Percentage of annual income
Experts suggest that the price of your car should be less than 50% of your after-tax annual income. If your after-tax annual income is $50,000, the absolute maximum price of you car should be $25,000. This is only if you have a stable job and know that you will be making similar or higher amount of income annually for the next several years. I like to keep this cap low. For example, when I bought my first car, I bought a car for less than 30% of my annual after-tax income. This helped me invest more and grow my wealth over the years. Believe it or not, I still own the same car and my income has more than tripled since I bought it, which was 13 years ago.
Car Affordability Calculator
Start backwards from your savings target rate
Another way to calculate how much you want to pay each month in auto expenses is to first determine your savings target rate.
Say for example, your monthly income net of taxes is $4000. Your target savings/investment rate is 10%. That amounts to $400 that you want to contribute to your investment account. Your rent/mortgage is $2000, groceries equal $300. You spend $200 on travel, eating out, movies, etc. You also have student debt that requires a monthly payment of $500. That makes it a total of $3600. Assuming you are also building an emergency fund by setting aside $100 a month in a money market or high yield savings account, you are left with $500 for monthly car-related expenses. To check out our budget template, click here.
Buy or Lease
Please don't lease a car. In the long run, leasing is always a bad decision. You end up paying a lot more in interest. Unless you can claim your car as a business necessity and claim lease payments as business expenses to get a tax benefit that's bigger than the higher interest you are paying on the lease, leasing is always going to be the worse option between buying and leasing.
Deciding whether to finance your car through cash or finance it through an auto loan comes down to five factors.
- Loan amount
- Amount of down payment
- Annual percentage rate on the loan
- Term of the loan
- Monthly payment
I will disagree with some financial "experts" when they say never finance a car through a loan. If you are able to secure an auto loan with a low APR, go for it. It is all about the opportunity cost. You may be able to continue to invest what you have saved so far in an investment vehicle that provides a better return than the interest rate you will pay on the car. However, if the APR quoted is very high and your savings are sitting in a checking account earning zero interest, you are better off making a cash purchase. Make a cash purchase only if you have already built an emergency fund. Otherwise, get a loan.
Typical terms on a loan are 36, 48 or 60 months. The longer the term of the loan, the higher you will pay in interest over the lifetime of the loan. I recommend a 36 month term. Typically, shorter term loans will have lower APRs than longer term loans.
Let's consider an example. Let's say you want to finance a car with a loan of $20,000. The 36 month term loan offers an APR of 4.0% and the 48 month term loan offers an APR of 4.25%. That makes the monthly payment on the 36-month term loan equal to $590.48 and on the 48-month term loan, the monthly payment equals $453.82. That makes the total amount in interest for the first case to be equal to $1257.27 and that for the second loan to be equal to $1783.45. You pay $526 more in interest by opting for the 48-month term loan. Even if both loans offer a 4% APR, you end up paying $418.62 more for the longer-term loan. Increasing the term to 60 months will increase this difference by $842.56.
Of course, if your monthly car payment budget is lower than the payment calculated for the shorter term loan, you have no option but to go with the longer term loan. You simply cannot afford the monthly car payment that comes with the 36 month term loan.
And this brings me to the a very important section, which is the reason you are buying this car and the answer to that question is beyond how much you can afford.
Luxury or as a means of transportation
What is the purpose behind buying this car? Are you looking for a means of transportation? Perhaps, your old car broke down and you desperately need a car to go to work so that you can make money. Or you have grown your family and you need a bigger car.
Or does this car symbolize your status in society? Perhaps, your friends own fancy luxury cars and you want to fit in. Or you have a prestigious job and want to appear wealthy. Or maybe, your job is client facing and helps you make a better appearance and in turn leads to making more money in your job or business.
There is nothing wrong with wanting or driving a luxury car. However, try to understand the reason behind wanting to drive a luxury car. If you are already a millionaire, you don't even need my advice. You can afford that Lamborghini. However, if you are on the path to becoming financially independent, think twice. A luxury car will set you back on your financial journey.
Financial pundits, many multi-millionaires, and even some billionaires drive modest cars. A great example is Warren Buffet. He is one of the wealthiest men in the world and still drives a 2014 Cadillac XTS. Jeff Bezos still drove a Honda Accord two years after Amazon went public. Larry Page drives a Toyota Prius. Jared Dillan, who writes for Mauldin Economics, drives a Toyota. These are intelligent investors who chose to focus on building wealth and other important things in life instead of buying flashy cars to show off as a symbol of their wealth. Here is an article from Business Insider on cars owned by 10 of the wealthiest people in the world. It may help you gain some perspective and help reflect on your reasons for wanting a luxury car.
What kind of car should I buy
Buy a reliable car. I have not seen many issues with Toyotas and Hondas. I have owned only one car in my life, which I still continue to own as of 2020. It's a Toyota Corolla. It has never broken down. There have been minor issues over the years but most dealers have the necessary auto parts and won't charge you exorbitant fees in diagnostics and repair. If you live where it snows a lot, by all means, go and buy the most reliable AWD. If you have a large family, go for that reliable mini van or SUV. Analyze safety ratings, mileage and other factors that may be important to you. Don't go for a specific brand name.
New or used car
I am the kind of person who does not understand everything under the hood of the car. My first car was a new car, which had a warranty and I didn't want to deal with any unknowns. However, if you are a car expert, buying a used car can be very economical. Especially, if you are still in school or if it's your first car. I, personally, prefer to buy new because I don't want to deal with hassle of figuring out what is wrong with the car.
If I were to buy another car, which would be after my Corolla can no longer be driven, I would always buy the most reliable, cheapest car with a good mileage and something that most body shops can fix. That way I don't to worry about car troubles and can fix on important things, things that create value for me, both personally and professionally.