Buying a car should start with a budget. Yeah, I know, a budget sounds boring, but it serves as your guiding light to know how much you can afford when buying a car. It will also determine whether to buy new or used and how you’ll pay for it. It’s the starting point to help make a difficult decision easier. With car prices and interest rates on the rise in our post pandemic economic landscape - budgeting appropriately and living within your means is more important than ever. You really need to find a car that you can afford comfortably to allow yourself room for further inflation impacts to your personal finances.
If you’re financing your purchase, the rule of thumb, according to money and car experts alike, is the 20/4/10 ratio. Here’s how it works and why you should implement this strategy when budgeting for your next car purchase.
Why you should make a 20% downpayment
If you put any less down, you could be paying more than what the car is worth by the end of the year, it is also known as negative equity. According to Edmunds, a car depreciates in value by 9% as soon as you drive it off the lot. By the end of the year, that same car has lost about 19% of its value.
Think about it, if you buy a $20,000 car with 0% down by the end of the first year your car is worth $16,200 through depreciation. However, assuming 4% annual percentage rate (APR) interest on a 5-year loan you’re paying about $370 per month your remaining amount owing is roughly $15,560, but this amount does not include applicable taxes, fees, and finance charges of the loan itself.
However, If you put 20% down, your car payments are $295 per month and your remaining amount owing is $12,460 (not including all the extra charges). Still. you owe less, you’re paying less per month, and you’re nearly halfway to paying off the car completely.
A lower monthly payment makes affording gas, maintenance, and auto insurance a little easier on the pocketbook.
Limit your car loans to 4 years or less
The longer your term, the more interest you’ll pay. Now this may seem like a tougher strategy to accomplish in the current market as interest rates on shorter term loans are higher than longer term loans, but it's the smarter longer term financial decision.
Financial experts tend to agree on a car loan being 48 months, or if you can afford it, go to 36 months. We're not saying you can't go for a longer term loan especially if 48 months is too hard on your budget, you can always stretch to 60 months but it's never fiscally wise to go further. If you can’t make the payments work within these timeframes, you should probably be looking at a less expensive car.
Consider the cost of insurance when budgeting
Insurance is often overlooked during the purchasing period, but it's required to legally operate a vehicle in Canada. For some people, they find out too late in the purchasing period that they cannot afford the auto insurance for the vehicle they've recently purchased. It's important to know that your lender may require more expensive car insurance than your budget allows for, as they seek to protect their investment.
For instance, the minimum required third-party liability coverage for Ontario car insurance is $200,000. It's even cheaper for a Quebec auto insurance policy, where the minimum is set at $50,000. To be fair, the vast majority of drivers will opt for a higher level of coverage, and your financial lender is no different, as they will often require you to carry more than the minimum, in the range of $1-2 million for third-party liability coverage. Consequently, the more coverage you have translates to a more expensive monthly premium. They will also require you to add-on endorsements like collision insurance and comprehensive coverage to protect the vehicle if it's ever damaged. All in all, these additions only increase the price for auto insurance.
So what can you do to find affordable insurance within your budget? Always shop around and compare car insurance quotes during your car buying process. If you have a short list of vehicles you are interested in, seek out quotes from your local brokers or comparison shopping online through sites like Ratehub. The price of car insurance should be built into your budget before deciding on, which car to purchase as the type of car will impact the price you pay for insurance. Comparison shopping will allow you to track down your cheapest rate.
Read more on: how car insurance rates are calculated.
Why payments should be less than 10-15% of monthly pay
I used the neuvoo income tax calculator to figure out that a $50,000 salary means you take home $38,869. If we calculate 15% of that take-home pay, we end up at $5,830.35 or car payments of $485.86 per month.
If you want the best car you can afford at that salary, you could buy a $30,000 car, put a $6000 down-payment, get a 5-year loan at 4% interest and end up at monthly payments for 5 years at $442.
But, you still need to compare car insurance plus evaluate the gas mileage and maintenance costs of your new vehicle. If you’re setting aside $100 per month in maintenance, $200 for gas, $200 of insurance, and $50 in parking fees – you’re spending almost $1000 per month to drive a vehicle.
That $100 transit pass might not look so bad anymore.
If we’re staying with above example, at about $1000 per month on your car, you’re left with $26,869, or roughly $2,200 a month, for rent, groceries, clothes, dining out, tax free savings accounts, GICs, etc. for 5 years.
How much car can you afford: car affordability calculator
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The question, “How much car can I afford?” is based on budget. We’re personal finance writers, it’s what we do. What if we altered the question ever so slightly to “How much should I spend?” If it’s not based on budget, and strictly preference, there is another rule of thumb you can follow.
- 10% of your salary – If you believe buying a car is a necessary evil. You only drive because your work requires it, but you get no joy out of it.
- 20% of your salary – You want a safe, reliable, and affordable car for commuting and errands. It’s not about power or aesthetics, it’s about function.
- 50% of your salary – Cars are life.
Knowing the “rules,” here’s a quick reference chart. We used gross annual income in this scenario because the question is less about budget. However, because of the personal finance angle, we opted to not show the 50% to spend on a car, it’s not wise financial choice for a depreciating asset. It’s smart choice if that’s what you value and you can afford it.
The bottom line
Edmunds depreciation study revealed experts advising on short term loans, and limitations on how much you can afford based on your salary are all major factors in determining the car you buy. If you’re looking for a little more freedom, you could finance a used car and worry less about depreciation.
Buying a car is a major life decision and doing all your research can help you make the smartest, most informed choice when you’re ready. The key is to do the research, build your budget and stay within your financial means.
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