Don’t Over-Buy Your Next 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?
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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.
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.
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:
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?
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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?”
Should I Buy a New Car or Used Car? 