Over the years, I’ve learned that there’s a big difference between choosing a car based on what I want and choosing a car based on what I can afford.
Since I tend to default to the former strategy, I typically enlist the help of my dad or someone else who’s good with money to help me see past the alluring vision of that oh-so-tempting (and expensive) car.
What makes me feel marginally better is knowing I'm not the only one who has a tendency to shop for more car than she can afford. Read on to learn how to sidestep this common—and pricey—car buying mistake!
The 1/10th rule of car buying
Sticking to the 1/10th rule is a great way to avoid spending more than you can afford on a car.
The 1/10th rule states: "Spend no more than one-tenth of your gross annual income on the purchase price of a car."
This rule is very similar to what many other financial gurus advocate, to spend no more than 20% of your net take-home pay on a car purchase (basically, it works out to about the same).
For example: Let's say you earn $60,000 per year in gross (pre-tax and contributions) pay.
- 1/10th of this is $6,000.
- This means you can only afford $6,000 per year (all-inclusive) for a new or used car purchase.
Bonus tip: Knowing this in advance helps you not only figure out how much car you can afford, but it can help you choose the right loan term as well. Let's say a three-year loan would mean $500 per month in loan payments. But a five-year loan would mean $325 per month in payments. Knowing that you can only spend $6,000 per year on your new car purchase would mean you would want to opt for the five-year loan in order to stay within your budget.
The 20/10/4 rule
Another similar rule that can be helpful in calculating how much car your family can afford is the 20/10/4 rule (for more see the Chicago Tribune).
This National Foundation of Credit Counseling (NFCC) rule takes budgeting one step further by factoring in your down payment—either by cash or trade-in value of a vehicle.
- 20 = a 20% down payment.
- 10 = no more than 10% of gross annual income for total monthly vehicle cost.
- 4 = loan term of four years.
For example: Here again, let's say you earn $60,000 per year in gross pay, but now you’re putting down 20% of your car's retail value as a down payment.
- The car you’re buying has a sticker price of $32,000.
- 20% of $32,000 is $6,400 (that’s your down payment).
- So now you have $25,600 left on the principle to pay off.
- Your goal is to pay it off over 4 years.
- However, this would mean paying $534 per month in loan payments alone, which is more than 10% of your gross annual income ($534 times 12 = $6,408).
- This will help you know that you’re shopping for more car than you can afford.
Calculating the total cost of your new car
Ultimately, whether you buy new or used, any "percentage of" purchase rule you choose to use as your go-by will only apply accurately if you know the total cost of your new car.
What your new car truly costs you:
- Principle loan amount (split into monthly payments)
- Interest on those monthly payments
- Tax, title and license fees
- State sales tax on the purchase (if applicable)
- Miscellaneous dealer fees
- Auto insurance premiums
- Fuel cost
- Maintenance and repairs (including new tires)