How Much Car Can I Afford?

car sitting on a pile of cash
Figure a budgeted amount and stay within it when buying a new or used car.

Car buying guides – this one included – always stress the importance of setting a budget before you start shopping. The reason is that without a hard limit you're likely to leave the dealership having spent much more than you wanted. You may even have spent more than you can afford. But how do you decide on a limit?

A Better Question to Ask

If you're a prudent saver you'll be paying cash and you don't intend parting with more than you have squirreled away. Most car buyers aren't that disciplined though, which is why financing was invented.

When you finance, you're borrowing money and paying it back over a period of time. Buying the car becomes easier but figuring out what you can afford is much, much harder. In fact, rather than asking, “How much car can I afford?” you should really be asking yourself, “How long will I want to keep this next car?” Here's why.

Reducing the Monthly Payments

Whether leasing or actually buying, the tendency is to look at the monthly payment you're signing-up for. The problem is that it's very easy to reduce the monthly outgoing. All you need do is extend the term of the loan or lease. To ignore the impact of interest for a moment, if a three year loan will cost $700 per month, spreading it over six years cuts it to $350 per month.

If you're wondering who takes out a six year car loan, the answer is, lots of people. (Perhaps they don’t take advice from autocheatsheet.com!) An article from June 2016 in Forbes magazine reported car loan data from Experian. This said the average amount financed for a new car was $32,000, the average monthly payment was $503 and the repayment term was 68 months or almost seven years.

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The Downside of Lower Monthly Payments

There are two reasons why spreading a loan out over a longer period isn’t a good idea. First, you'll be paying a lot more in interest, and even if you double the loan period the monthly payments won't halve. Second, you'll be driving that car for the next six years. That might not be a problem if you really love it, but what if things change? For example:

Unforeseen future issues:

  • Gas prices jump and you need something more economical.
  • Your family circumstances alter and you need a larger car, or just want something smaller.
  • You want a car with some new technology that wasn't available when you bought yours.
  • Reliability starts to become a problem and you're spending more and more on repairs.

This last point – reliability – can be a particularly big issue. New cars come with warranties of three years, sometimes longer, but after that you’re on the hook if anything goes wrong. In addition, the likelihood of expensive repairs or maintenance being needed rises quickly as a car ages. For example, there will be new shock absorbers and maybe a brake fluid flush or two.

Getting out of the loan early

A car salesman might tell you not to worry about a longer term loan because you can get out of it early. That's true, but it's not quite that easy. Two things can happen:

Possible issues trading your car early:

  1. The balance remaining on the loan doesn't just go away. Instead it gets rolled into the next loan so you're paying it off over a longer term and paying even more interest.

  2. If you try to get out of a six year loan after just two or three years you'll likely be “underwater” or “upside down” to use some car salesman jargon. What that means is you'll owe more than the car is worth, so selling it won't raise enough cash to pay off the outstanding balance.

Figuring Out Affordability

Once you've got a feel for how long you want to be committed to a car you can start looking at what you can afford. There are some easy-to-use calculators available on line that show what you could spend for a given monthly repayment and loan term. (The affordability calculator at cars.com is very good.)

One of the beauties of these is that they let you weigh up alternative scenarios. For example, you can look to see how much difference the size of the down payment makes or the impact of a lower interest rate. (That might encourage you to work on improving your credit score!) You can also enter the Forbes/Experian numbers mentioned earlier to conclude that new car buyers must be making a down payment of more than $10,000.

Still unanswered though is the question of the monthly payment. How do you arrive at that number?

Budgeting for Your New Car

That paragon of sensible advice, Consumer Reports, suggests performing a cash flow analysis. Note down all your monthly outgoings – rent or mortgage, utilities, food and so on – and deduct the total of those from your after-tax income. But don't think what's left is available for a new car! You'll probably have to pay tax and registration fees on the car, and you should always leave a buffer for the unexpected.

CR also suggests heeding the 20/4/10 rule sometimes trotted out for car buying. This says you should aim to put at least 20% down, limit the term to four years, and spend no more than 10% of your gross income on monthly payments. Read more about this in my article about "How Much Cash Down on a Car?"

Budget for a Car Two Ways

Buying a car is different to buying just about anything else. While there are lots of practical aspects to consider it’s a decision made with the heart as well as the head. That means there’s a risk of getting carried away and spending more than you can afford, (which of course is what the salesman would like!)

The answer is to figure out a budget, but unless you’re paying cash, (lucky you!) don’t think only in terms of the actual price. Consider how long you want to be making payments on it and what kind of monthly sum you can actually afford. Only then will you know exactly how much car you can afford.

Be a Smart Car Shopper

Car shopping online is the smart thing to do. It's easier than the old way of sorting through dozens of misleading newspaper ads or trudging round dealerships. And since dealerships look at online car deals as "high volume - low profit" transactions, you'll probably get a better deal. Do yourself a favor and make online car shopping the way you buy your next car. For more hints and tips on navigating the new and used car buying process, spend some time browsing through the rest of my website AutoCheatSheet.com.

Once you've figured you're budget and ready to start shopping for you next new or used car, take a look at either my, “New Car Buying Guide” or “Used Car Buyer's guide” for insider tips and secrets on how to buy a car and avoid dealer scams.

As always, I recommend using an online referral service such as CarClearanceDeals or CarsDirect before visiting a car dealership. Their free online price quotes will automatically include any discounts or cash-back incentives currently available in the marketplace.