How Much Car You Can Really Afford (By Salary)
The latest trend, as per headlines, is thousand-dollar car payments becoming the new norm.
Shockingly, over 17 percent of new car buyers are committing to payments in the four-figure range, and these car payment stories are making waves on social media.
That’s crazy!
So, in this article, we'll delve into how much car you can realistically afford. I've categorized it into three salary ranges: individuals earning 40K, 80K, and 150K per year.
Average Car Loan Term
Many car dealerships today may attempt to persuade you that you can afford a more expensive car than your actual budget allows by extending the loan terms.
Currently, the average car loan term in the U.S. is 68 months for new vehicles, and data indicates that those with lower credit scores are inclined to opt for even longer loan terms.
Moreover, car loan interest rates are on the rise, making car payments more expensive than in the past.
So, we'll go over some essential rules for buying a car, explore ways to cut down on car payments, discuss the pros and cons of financing versus leasing, and provide specific figures for the three salary ranges mentioned earlier.
Let's dive in to the first car buying rule: the 35% rule.
#1: The 35% Rule
The 35% rule dictates that you should not spend more than 35% of your gross annual income on a car.
- For instance, if your yearly income is $40,000, your maximum budget for a car would be $14,000.
- Similarly, if you earn $80,000 per year, your car budget should not exceed $28,000.
- If your annual income is $150,000, then your upper limit for a car price is $52,500.
However, it's important to note that the 35% rule is quite ambitious and primarily targets car enthusiasts or individuals who take great pride in owning a specific type of car.
If your goal is to have a basic car to take you from your home to work, then adhering to a more conservative budget might be advisable.
#2: The 25% Rule
You have the flexibility to adopt a more economical approach, perhaps making it the 20% rule or even the 25% rule.
The 25% rule, in my view, strikes a more balanced and reasonable approach.
This guideline allows for a car with some additional features without being overly basic.
Staying within this range ensures that your car remains financially manageable.
So, if there's one takeaway from this video, remember the 25% rule, not the more aggressive 35% rule.
Next, we're going to talk about how much you pay each month for your car and what your targets are that you should try to reach.
But remember, the most important thing is to pay attention to how much the car actually costs in total when you buy it.
Now, let's move on to the next car buying rule, which revolves around the affordability of your car and its monthly payments.
#3: The 20/4/10 Rule
It's called the 20/4/10 rule. The first part suggests putting down a 20% down payment on your car.
For instance, if the car is $40,000 right out of the gate, it recommends a $8,000 down payment when purchasing.
The idea behind this is to make managing the loan payments easier over time.
Having 20% upfront ensures you are in a financially responsible position to buy the car.
If you finance the entire car amount, it can lead to problems. Let me illustrate with an example:
Suppose you buy a car for $48,000 and finance the entire amount.
After one year, the car's value drops by 20% (which is common by the way to have a car depreciate that much), which means your car is now worth $38,400.
If you want to sell it, you'd get $38,400, but you might still owe more than that on the loan, leaving you "underwater" on the car.
Making a 20% down payment reduces the financed amount, helping you build equity in the car faster.
This addresses one of the major costs of cars: depreciation.
Basically, you're constantly putting money into a depreciating asset when it comes to cars so a really good option is to consider buying a used car that's three to five years old, where a significant portion of depreciation has already occurred.
What The 4 Means?
Let's move on to the next part of this rule, the four.
The "four" signifies that you shouldn't finance a car for more than four years.
This time frame is recommended because it keeps your monthly payments reasonable and prioritizes paying off the car before it depreciates too much.
When you extend your loan term to five, six, or seven years, you end up paying more in interest over time.
For instance, if you finance a $40,000 car for four years, the total interest paid is $3,372.
However, if you extend it to six years, the total interest jumps to $5,105, which means you're throwing away over $1,700 to interest.
The challenge in America and other countries with auto loans is that the 20/4/10 rule is actually reasonable, but societal pressures often lead people to buy cars well beyond their means.
Many feel it's not reasonable because it doesn't get them the car they truly desire.
I mean, if we refer back to the previous example, with a four-year term, you need to pay $736 per month for a car, while the same car will cost you $515 a month by extending it to six years.
This leads to a situation where two people paying the same amount monthly might be driving different cars.
Maybe one drives a really cool Mercedes, maybe costing them $500 a month.
While another is driving a Honda Civic, which also costs them $500 a month.
Now, societal pressures can make the guy with the Honda feel uneasy, as he is paying $500 a month, but his term could be way shorter.
Most people will go for a longer car loan term, so they can get their dream car or a car that’s actually way over-budget for them, so it's crucial not to fall for this trap.
What Does The 10% Means?
Let's dive into the final component of the 20/4/10 Rule, the 10.
This 10 signifies that you should strive to keep your monthly car payments, including insurance and maintenance but excluding fuel costs, to less than 10 percent of your gross monthly income.
But remember to factor in fuel costs separately into your overall budget.
Here is a breakdown for different income levels, ranging from $40,000 to $180,000 per year, and the corresponding affordable car payments based on this rule.
A quick and easy way to calculate your maximum monthly car payment is to divide your gross annual salary by 120.
- For a $40,000 annual income, the affordable car payment would be $333, including maintenance and insurance.
- At $90,000 per year, it goes up to $750 per month.
- For a $120,000 annual income, the affordable car payment becomes $1,000 per month.
- And at $180,000 a year, you can get up to $1,500 a month worth of car.
However, just because you can afford a higher car payment doesn't necessarily mean you should max it out.
It's wise to be prudent with your expenses.
Spending less on a car allows you to have more cash on hand, which can be invested, saved for a house, or used for various other purposes instead of being tied up in a car payment.
One common question here is why 10%?
Why not 15% or 20%?
The 10 percent limit is set to ensure that your budget accommodates other financial needs and unexpected situations, giving you financial flexibility.
#4: The Dave Ramsey Method
The next approach is the Dave Ramsey method, which for those unaware, Dave Ramsey is a prominent figure in personal finance, wealth building, and savings.
With five New York Times bestsellers, ownership of the largest independently operated radio talk show, and over $600 million in fully paid-off real estate, Ramsey is a notable authority in the field.
According to Ramsey, in an ideal scenario, you should purchase a car outright with cash – no loans, no monthly payments, just a car within your financial means and drive it until it doesn’t work anymore.
He argues that the monthly expenses associated with car ownership divert resources from potentially more rewarding opportunities.
Given that cars are generally poor financial investments, especially if your primary goal is efficient transportation from point A to point B, the specific make or model becomes less relevant.
Ramsey advocates that the cost of your car should not exceed half of your take-home salary.
For instance, if your annual income is $60,000, your car's total value should stay under $30,000.
This philosophy extends to millionaires as well.
As Dave Ramsey said, his survey of over ten thousand millionaires revealed that the average millionaire drives a four-year-old car with 41,000 miles.
Moreover, 8 out of 10 millionaire car owners drive away without a car payment, contributing to their financial success.
Should You Buy, Finance, or Lease?
Okay, let's delve into the decision-making process of whether to buy or lease a car, and if buying, whether to pay in cash or finance.
#1: Leasing
Starting with leasing, it's a favorable choice if you enjoy driving a new car every few years or if you prefer a lower monthly payment.
Leasing comes with advantages such as a minimal or zero down payment, warranty coverage, and potential tax benefits for small business owners.
However, there are downsides like mileage limits, potential extra charges for exceeding them, and the obligation to return or purchase the car at the end of the lease term.
#2: Buying
For those aiming for long-term car ownership, buying is usually the financially sound choice.
Now, when it comes to paying for the car, you have the options of cash or financing.
Paying in cash can be appealing if you want to follow the Dave Ramsey method and value a car without monthly payments, appreciate the peace of mind, or possibly get a discount for paying all in cash.
This might be particularly attractive if you're not an investor and your cash is just sitting in a bank account not earning you any interest, which is unlikely given the audience I have.
#3: Financing
On the other hand, if you are watching my channel, you are probably some type of an investor, which means financing tends to make more sense due to the concept of opportunity cost.
Let's say you pay $30,000 upfront for a new car.
That's $30,000 that could potentially be invested elsewhere, earning returns with compound interest instead of sitting idle.
The Opportunity Cost
Let me give you an example.
If you allocate 20% as down payment for a $30,000 car, you still have $24,000 in cash at your disposal.
Imagine if you invest this sum in the S&P 500, which historically yields an average return of eight to ten percent annually.
In five years, that initial $24,000 investment could grow to $37,000.
If you're thinking long-term, especially in terms of retirement, this amount might even swell to over $318,000 over a 30-year period.
While it's understood that real-life decisions rarely align perfectly with the concept of opportunity cost, this example aims to illustrate why financing tends to be a more financially strategic option than paying the entire amount upfront in cash.
What Should You Do To Save Money On Cars?
Having said that, here are three tips for saving money when purchasing a car:
1. Shop Around for Insurance Rates:
Take the time to call different insurance providers and inquire about their rates.
Insurance companies often compete for customers, so checking with various providers can help you secure a better deal.
For instance, if you currently have AAA Insurance, consider reaching out to State Farm to compare rates.
Many individuals who switch car insurance providers report saving between $100 and $200 per month.
2. Opt for a Used Car, Preferably Three Years Old:
Consider buying a used car, especially one that is around three years old.
A three-year-old used car still maintains its reliability while having significantly reduced depreciation costs.
This can lead to substantial savings compared to purchasing a brand-new vehicle.
3. Factor in Maintenance Costs:
Before deciding on a car, use tools like the "True Cost to Own" calculator on edmunds.com.
This calculator helps estimate the total cost of ownership, including maintenance, insurance, and repairs over time.
Sometimes, a luxury car like this Mercedes-Benz with a lower upfront cost may end up costing much more in maintenance and repairs compared to a more affordable alternative.
Lifestyle Creep
Okay, after reading this article, you might be a bit disheartened about how much car you can actually afford.
However, it's essential to realize that many people in the United States are buying cars that exceed their financial capacity.
So if you're managing to afford a car following the 20/4/10 rule or even the Dave Ramsey method, that's commendable, and you should take pride in it.
If you found this article helpful, be sure to share it with your family and friends who are shopping around for a car!
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- Ivan