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.
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:
The downpayment on your car should be at least 20% of the purchase price
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.
Are you paying the best price for car insurance?
Limit your car loans to 4 years or less
The longer your term, the more interest you’ll pay. It’s also important to know that your lender may require more expensive car insurance than your budget allows when borrowing money to protect their investment.
For instance, the minimum required third-party liability coverage for Ontario car insurance quotes is $200,000. In Quebec, the minimum is $50,000.
A financial lender will often require you to carry more than the minimum, or $1-2 million, in third-party liability coverage which translates to a more expensive monthly premium. You can shop around for the best car insurance quotes to reduce your rate but the extra added endorsements like collision, comprehensive, and extra third-party liability will cost more than a no-frills policy.
Financial experts tend to agree on a car loan being 48 months, or if you can afford it, go to 36 months. If 48 months is too hard, you can stretch to 60 months but never further. If you can’t make the payments work within these timeframes, you should probably be looking at a less expensive car.
Monthly payments should be less than 10-15% of your take-home pay (after taxes)
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
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, 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.
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