There’s no getting around it – cars are expensive. They’re starting to cost more and more, too. Kelley Blue Book reports that the average new car transaction price in June reached $33,340. That’s an increase of $209 from May and $821 from June 2014. The rising average price of a new car shows that consumers
There’s no getting around it – cars are expensive. They’re starting to cost more and more, too. Kelley Blue Book reports that the average new car transaction price in June reached $33,340. That’s an increase of $209 from May and $821 from June 2014. The rising average price of a new car shows that consumers are willing to pay more and more for a new car. The question is, how much should you pay for a new car?
How much you should spend on a car depends on a number of factors. Most car buyers finance a car purchase – that is, they take out a loan to pay for it, rather than paying for it with funds they’ve saved up (to learn more about car loans, read How to Finance a Car and Get a Car Loan). Because financing a car means committing to a monthly loan payment for a period of time, your monthly budget plays the biggest role in deciding how much to spend on a car. Keep in mind, however, that your car loan payment won’t cover all your car-related expenses. You’ll still have to pay for things like insurance and gas, as well as other less regular costs, like car registration, taxes, fees, repairs and maintenance.
Buying a car is often compared to buying a house. Both are large purchases that most people finance. They both also come with costs beyond the purchase price for things like insurance and maintenance. However, while most experts agree that housing costs should be about 30 percent of your monthly take-home pay, their rules for how much you can afford to spend on a car are not as clear-cut.
Some experts recommend that your monthly car costs, including the payment and other expenses, should be no more than 15 percent of your net monthly pay, so long as you don’t have any debt other than a mortgage. Others recommend that the price of the car you buy should be no more than half your yearly income. If you have revolving debt payments, like credit card debt or student loans, some financial experts recommend looking at your total debt costs as a whole to determine how much you can spend on a new car, with an eye toward keeping your total monthly debt repayments, including mortgage and rent, under 36 percent of your monthly take-home pay.
Let’s take a look at each of these rules and how they impact how much someone making $50,000 per year can afford to spend on a new car. We’ll assume that this person pays 11.64 percent of their income in taxes, leaving them with $44,180 in net pay each year. Of course, their actual take-home pay will likely be lower, as they’ll need to pay for health insurance and save for retirement, but this at least gives us a ballpark figure of $3,681 in net pay each month.
Using the first rule of how much car you can afford, this person’s monthly car ownership costs should not be more than $552. That’s a pretty big chunk of change, but keep in mind that needs to cover gas and insurance while leaving some money left over for less regular expenses like repairs and maintenance, registration and taxes on the car. Car insurance rates vary quite a bit depending on things like where you live and your driving record. The median average insurance rate in the U.S. is $1,248 per year, which works out to just about $100 per month in insurance. Assuming $125 per month for gas, and $50 per month to save for things like registration and repairs, that leaves our hypothetical buyer with $277 for their monthly car payment. Plug this number into a car affordability calculator with a $2,000 down payment, 4 percent sales tax and a car loan lasting five years with no interest, and a car costing just under $18,000 makes financial sense for this person. With $18,000 to spend, this car buyer could get a new affordable small car, or a used midsize car or compact SUV.
Of course, this person may not qualify for a no-interest loan, and shortening the loan term will increase the payment. They could also lower their monthly payment by having a larger down payment. What’s interesting about this number is that it is much lower than the rule of using half of your yearly salary. Under that rule, our buyer would be able to spend $25,000 on a car. For someone without other debt, low car insurance and low fuel costs, that price may work, but it’s a much less conservative approach to making car ownership fit your budget.
Now let’s use the same assumptions to test the rule that monthly total debt payments should not be more than 36 percent of monthly take-home pay. With monthly net pay at $3,681, allowing 36 percent for debt repayment gives our car buyer $1,325 for debt repayment. Let’s say that our hypothetical car shopper has student loan payments right at the national average of $242 per month, and credit card debt of $5,596, which is also right on the national average (notice a pattern here?). With that level of credit card debt, a monthly repayment of $100 is reasonable, and would allow our car buyer to be paying more than the minimum balance on the credit card, which will help erase the debt faster. Using the 36 percent debt rule, this person can afford a monthly car payment of up to $983.
Having $983 available for car ownership costs seems great, but you have to remember that the 36 percent rule includes housing payments. Our car buyer needs a place to live when making all these payments, and assuming they have a house priced at the national average of $272,900 and a 30-year mortgage at 4 percent, they’re paying $1,041 each month on their mortgage (and that’s before taxes). With that mortgage and other debts, the 36 percent rule says that this person can’t afford a car at all.
If the car buyer is a renter and pays $769 per month in rent, which is – you guessed it! — the national average monthly rent for a one-bedroom, one-bath apartment, they have $556 left over for debt, and with their student loans and credit card repayments, they have $214 per month to spend on a car payment. Assuming 4 percent sales tax, a $2,000 down payment and a five-year, no-interest loan, that gives the buyer a budget of around $14,000 to spend on a car, which can get them a new affordable small car, as well as some good used car options.
The recommendation you follow to determine how much you can spend on a car depends on how conservative you like to be with your finances. You could spend half of your salary on a car if you have a secure job, no other debt and your other expenses are fairly limited. If you don’t have debt beyond a mortgage, see if spending up to 15 percent of your monthly net income on car expenses makes sense for you. People who have other debt, live in an area with a high cost of living, or who want to avoid biting off more than they can chew debt-wise, should use the 36 percent debt rule.