From a young age, many Americans dream of having their own car — and it makes sense. For many, a car represents the freedom to go where you want, when you want without the need to rely on public transportation or ride sharing. But we know that this freedom isn’t free.
Second to a new house, car buying is the next largest purchase most consumers will make in their lifetime. And just as with buying a house, you’ll need to prepare yourself and your finances for such a major expense.
If you’re wondering how much car you can afford and how to save up for one, never fear. There are tried and true methods to help you figure that out. Read on to see how you can join the more than 17 million individuals who bought a new (or new to them) car last year.
First, Consider the Total Cost of Ownership Before Purchasing
While owning a car might be a dream for many, is it worth the cost in reality? Knowing the true cost of ownership can help you determine if buying a car is a smart decision for your personal financial situation.
Obvious and Hidden Ongoing Costs of Car Ownership
Often, when people think about the cost of buying a car, they focus on the purchase price, their monthly payment, and maybe insurance and fuel. In reality, the costs related to owning a car include a number of other important factors.
According to a study by AAA, the average annual cost to own and operate a new car is $8,849, assuming you drive 15,000 miles per year. The figure looks at the top 45 models sold in 2018 and takes into consideration the loan interest, insurance, and cost of fuel, as well as some of the less obvious expenses such as maintenance, repairs, license and registration, taxes, and depreciation.
When thinking about buying a car, it’s important to think about all of these costs, not just the payments that come monthly. In particular, depreciation is a big one to consider, as it represents about 40% (or about $3,000) of the total cost of owning a car each year, according to AAA. This is even more critical for new cars, which lose about 22% of their value in the first year, according to Edmunds. That means if you were to buy a new car at the average $37,000 sticker price, in a year that car would only be worth $28,860.
Opportunity Cost of Cash Payments
Another important (and often overlooked) cost to consider is the cost of a down payment or cash purchase. Before we dig into scenarios below, let’s explain. Conventional wisdom recommends putting at least 20% down when you buy a car, and others will recommend buying a car with cash if you can.
It’s important to note that this wisdom was established back in the 1970s and 80s when even the best available interest rates were above 10%, and sometimes as high as 17%. In comparison, the same type of loan on a new car today would likely have an interest rate closer to 4% or 5%.
What this conventional wisdom doesn’t take into consideration is that you might be able to make more money by putting that cash into the market and letting it grow, even if it requires you to take out a larger loan on the car.
Let’s walk you through two examples:
Scenario 1: Paying Cash for a Car Outright
Let’s say you’re one of the few with tens of thousands in savings, and are thinking about depleting your savings account in favor of some new wheels for the average price of a used car, or $19,657.
Determining the exact cost in this scenario is easy: It’s the price of the car, including sales tax and title, and any additional expenses you’ll have to put down. To keep this scenario simple, we’ll assume $20,000. However, taxes and title can run up to 10% to 15% of the value of the car, so don’t be surprised when you go to sign at the bottom line.
Now, let’s figure out the opportunity cost of that decision. You have two options:
- Put that $20,000 toward your car.
- Invest that $20,000 in the stock market and instead take a five-year loan out at, say, 2.9%.
Now let’s assume that you earn an average annual rate of return of 7% on your $20,000 investment. Over the course of the loan’s five-year term, that $20,000 would earn you $8,050 in the market, while the loan would cost you $3,070 in interest. In this scenario, investing the $20K and taking out a loan would put an additional $4,450 into your pocket.
Scenario 2: Putting 20% Down
Let’s assume instead that you’re like the 85% of Americans who decide to finance your car purchase with an auto loan. The cost of the car will be broken down into the down payment, and then the monthly payments after that.
As with an outright cash purchase, you may not have considered the opportunity cost of putting your hard-earned money toward a vehicle. For instance, if you were to purchase a new car at the average price (as of January 2019) of $37,000 and follow the conventional wisdom of 20% down payment, you’d put down $7,500. Then, assuming you have good credit, you take out a loan for the remaining amount at a 3.27% interest rate.
Rather than make the suggested down payment, let’s instead assume you took out a loan for the full $37,000, and put that $7,500 into the market with an average return of 7%. In this scenario, you would earn an extra $3,019 in the market over the five-year period, and pay an additional $1,309 in interest. The net result is an additional $1,498. Not a bad return if you’re lucky enough to have access to low interest rates.
There is one important thing to keep in mind when thinking about opportunity cost: You should only consider opting to invest in the market if you can get a low interest auto loan that is under 5.5%. With any loan above 5.5%, you’ll likely pay more in interest than you would have possibly made in the market on a risk adjusted basis. In that case, you’re better off finding ways to minimize your loan payment.
No matter whether you choose to pay cash or finance your auto purchase, it is worth considering the total cost before pulling the trigger. And in almost all cases, your financial future will be best served by lowering the purchase price of the car.
Now, Let’s Determine Much Car You Can Afford
If you read through the above considerations and still find yourself in a position where the benefits of a car purchase outweigh the disadvantages, you’ll still need to ask yourself a key question: How much car can I afford?
First, you need to figure out your monthly take home pay. To do this, subtract what you pay in taxes every year from your annual gross income, then divide by 12. For example, if you make $60,000 each year, your calculation would look like this:
- $60,000 taxable income – 22% tax rate = $46,800 annual net income
If we then divide by 12, we arrive at $3,900 as your net monthly income. Keep this calculation in mind, as it is how you will determine the dollar amount from which you can deduct your monthly car payment.
Determine Your Monthly Payment
Conventional wisdom recommends that you shouldn’t spend more than 10% of your calculated take-home pay on car payments, and that total car expenses — including things like insurance costs, gas, registration fees, and maintenance — should be between 15% to 20% of your monthly net income.
We think this rule is outdated and results in people often buying cars they cannot afford. Instead, we recommend you calculate an affordable monthly car payment using the 50/30/20 rule to determine your monthly budget. This rule breaks your spending into three categories:
- 50% Net Income Toward Needs. This includes your rent or mortgage, as well as other living expenses like groceries, utility bills, vehicle-related expenses, and minimum monthly debt payments (e.g. credit card debt, student loans, or car payments).
- 30% Net Income Toward Wants. This is the fun category that includes things like travel, eating out, and other types of entertainment.
- 20% Net Income Toward Savings (or Financial Goals). This category includes money you put toward your emergency fund, retirement accounts, investments, and any acceleration payments you put toward debt above your minimums each month.
Using the example of a $60,000 gross annual salary above, we can then plug numbers into our trusty car payment calculator (instructions below) to find what an affordable monthly car payment would be as part of the 50% that goes toward needs.
In the scenario above — assuming you had rather affordable monthly living expenses and minimal debt payments, you could comfortably afford a monthly car payment of $395 and total car expenses of $700 each month.
The above will likely not be an accurate reflection of your personal financial situation. Perhaps you have a higher annual salary, or tend to spend more on rent and groceries. Don’t worry, you can use the calculator to fit your circumstances. To do so:
- Open the spreadsheet
- Click “File”
- Click “Make a copy…”
- Fill in the pink boxes on the spreadsheet with your personal information, and the calculator will help determine an affordable monthly payment for you
Determine How Much Cash You Should Put Down
Now that you know how much you can comfortably spend each month on a car, you can work backwards to determine a reasonable purchase price and down payment. You’ll want to ask yourself the following questions:
- How much can I take out from savings before impacting my emergency fund?
- Is my loan above or below 5.5% and am I better off putting cash in the market?
The answer to these two questions are pretty simple.
First, let’s say you have $40,000 in total savings and that you’re going to buy a used car for $20,000. This would leave you with $20,000 left over. If you spend about $2,000 a month on recurring expenses, you would need at least $12,000 (or six months of spending) in your savings for a healthy emergency fund. In this scenario, your funds would be sufficient to either pay a larger down payment or to buy the car with cash.
Second, as we mentioned above, any loan above 5.5% is considered a high-interest loan. These loans tend to be very costly in terms of total interest paid over the life of the loan and should be avoided if possible.
So, if your loan is above 5.5%, you should aim to put down as much cash as possible (assuming you still have a comfortable emergency fund). If your loan is below 5.5%, you can consider taking out a larger loan and putting the additional cash you would’ve used for the down payment in the market instead.
Determine the Loan Amount and Purchase Price
Now, let’s turn to the final question you’ll need to answer: What size loan can you comfortably afford? Or, what is a reasonable purchase price for you?
Let’s continue our example from above in which we calculated that an affordable monthly loan payment would be $395. Assuming you want to put $2,000 down on a five-year (or 60 month) car loan, and that you have a good credit score between 700 and 749 — we can use this car affordability calculator to determine how large of a loan you can afford. In this case, you could afford a car loan of about $21,500, with a purchase price of about $23,500.
With these costs in mind, we have a few recommendations. First of all, we suggest you buy used cars over new. As used cars on average cost significantly less than new cars, you free up cash you may have otherwise put toward a car for other financial goals, such as a new house or saving for retirement.
Also, given that some estimate that you save the monetary equivalent of a new car for every five years after your current car is paid off, it’s definitely worth your while to extend the life of your current vehicle. By completing routine maintenance, you can avoid buying a car every two years as many do, and instead invest that money in your future.
And finally, with depreciation costs in mind, we recommend staying away from any loan term longer than 60 months for new cars and 36 for used ones. This is because longer loan terms usually have both a higher interest rate and higher loan cost over time.
For instance, if you have a $20,000 loan at 6% for 84 months, you’ll pay $4,542 in interest, which is $1,343 more than if you paid the loan off in 60 months. Additionally, with a new car purchase, you run the risk of owing more on the car than it’s worth with a longer repayment term. If you are in an accident or need to sell the car before you pay off the loan, you could actually lose money on your purchase.
Save Up for Your Purchase
Now that you know how much you need to save, how do you actually do it?
Perhaps the easiest way to ensure your savings plan is successful is to automate the process. For instance, if you’re paid via direct deposit, you can tell your payroll department to divert a specific percentage of each paycheck to a high interest savings account. After all, if you don’t see that money appear in your regular bank account, you’re much less likely to spend it.
If diverting some of your paycheck to savings isn’t feasible in your situation — or you’d like to get to your goal faster — try decreasing your recurring monthly expenses, or lowering spending in your “wants” category. There are plenty of creative ways to save money that could decrease the number of days or months until you can purchase a car. For example, you might decide to ditch cable for a few months, or cancel that gym membership you never seem to use anyway.
Finally, if buying a car is a long term goal — say you know you won’t make a purchase for at least five years — you might consider putting some of your current savings into low risk investments or a brokerage account.
Ride Off Into the Sunset
Buying a car is a huge commitment. But for many Americans, it is a necessary expense.
Whether you’re in high school saving up for your first car, or an adult looking to purchase a new vehicle for your family, you should first determine an affordable monthly loan payment for your new car based on your annual income and monthly expenses. Then, using the tools above, you can calculate an affordable purchase price range for your vehicle, as well as determine a healthy down payment.
If you follow these steps, you can drive off into the sunset in your new car, enjoying that new (or new to you, at least) car smell and knowing that you’ve made a wise financial decision.