Financial Tip Friday: How Much Car Can/Should You Buy?

Financial Tip Friday: How Much Car Can/Should You Buy?

I have to admit I love the idea of having a nice brand new car. I mean who doesn’t love that new car smell. It’s all clean and wonderful. But I then snap back to reality pretty quickly because I realize that car will be worth at least 10% less the minute I drive it off the lot. And if I have to finance it that car payment will probably be with me for 3-4 years. Plus, the car goes down in value in general. So my euphoria for car buying goes down quite a bit. I have my own personal philosophy about buying a car. But different people have different perspectives.

Some people might want to buy a new car. To each his own right. That said, how much car should you get? In other words, if you make $5000 a year can you afford a $5000 car. How much car should you buy? What kinds of guidelines do you go by?

Determining how much car you can afford can be a bit difficult. There a lots of rules of thumb for buying a house. But what are some guidelines for how much should you spend on a car.

The Dave Ramsey Rule

I have talked about Dave Ramsey on this blog before. I am a fan of his helping people to get out of debt, but disagree with his investing advice. I do have to admit I also like his rule of thumb for buying a car. Now if Dave had his way you would never buy a car without paying cash for it. In fact, he doesn’t mind people buying nice cars, just as long as it is with cash. I have no desire to get a nice brand new car, but when thinking about a car he advises that all of your items with a motor should be no more than 1/2 of your annual income. In other words, if you get a first job and it pays you $40,000 a year then you shouldn’t get a car that is worth more than $20k. You don’t want the car to own you.

That is pretty good advice because if you think about it your car payment in that situation would be almost $400 to $500 per month. On top of rent, insurance, utilities, and other payments you might actually be better by eating your car.

The 20% Rule

Another rule of thumb is to think about the payment you will make on your car. Your car payment should be no more than 20% of your take home pay. Again, not a bad idea. But here is the problem. People will often amortize the loan out longer to afford that new car. The average car loan now is 74 months. That means it will take 6 years for you to pay off your car for something that will depreciate probably by about 60% or more. When I think about the money you throw out the window over those 6 years for a car payment my eyes glaze over. That is probably why I don’t want to buy a new car. I don’t car about how my car looks. As long as it runs that is fine with me. So 20% of your paycheck is fine, but extending the loan to longer (e.g. 3 years to 6 years) just to get a nicer car to too much for me.

The 20/4/10 Rule

Money Under 30 has a great rule that I think could be a good line. It is the 20/4/10 Rule. If you are going to buy a car and finance it you should put 20% down for the car, the loan should be no more than 4 years, and it should be no more than 10% of your paycheck. I really like this rule because it causes people to do some focusing on their budget. It also may restrict you on how much car you can buy. For me that is ok because I don’t want people to buy too much car anyway (the idea of the car not owning you).

The 100% Rule

The final rule of thumb is the 100% rule. That 100% rule is that you pay for your car outright. No borrowing. If you can only afford $1000 car then so be it. Save up and buy a nicer one because typically that $1000 car can last for at least a year or two. Ultimately, this is probably the safest option in terms of debt. However, you won’t have a new car. You won’t even have a slightly used car if you are just starting out. And a lot of us don’t like the idea of plunking down $15-20k right away. Writing that large of a check can be a bit daunting.

In the long-run it saves you the most money and I think is the best option, but unfortunately most of us (including me) don’t just have $20k lying around to buy a new car.

What About Leasing?

Lots of people want to get a new car through leasing. Personally, I think leasing in the vast majority of situations is the WORST option you can do. Financially, it is the most expensive way of owning a car. There are a number of reasons why I don’t like a car lease (or fleece as Dave Ramsey likes to put it). First, you never actually own the car. Second, you have a restriction on the number of miles you can put on the car (we commute and it wouldn’t work for us). Third, you have a perpetual car payment. Yes it might be lowered but in the long-run it could cost you money. Fourth, you are perpetually beholden to someone else. Frankly, I don’t like owing the bank or whoever money. Leasing is basically a long-term rental of a car.

There are times when a lease might be a good idea. For example, if you get a reimbursement from your company for a car or if you are really paranoid about safety (although most cars now are extremely durable. The average car on the road is 11 years old for a reason). But generally I am not a fan.

The Bottom Line: If you are looking to buy a car soon and don’t know how much you can afford maybe look at these rules of thumb and act accordingly. If Mrs. ROB had her way I would be getting a newer car. For the moment I am content to drive my 2009 Nissan Sentra with scratches, 118,000 miles and the like until the wheels come off. The maintenance I spend each year is much cheaper than the $300 to $400 car payment I would have each month. Happy Car Hunting!

4 thoughts on “Financial Tip Friday: How Much Car Can/Should You Buy?

  1. There are a ton of options out there for how to purchase a car and how much you can truly afford. I’ve had written on my blog that you should never finance, but I can see a few circumstances where it’s ok to finance. As long as you’re being economical with your purchase and get a low interest rate, I don’t see a reason why you shouldn’t finance. Ex: 0% interest on a Toyota Corolla, Honda Civic, etc…those are ok purchases in my opinion.

    There’s also the argument that you shouldn’t buy new since the value drops once you drive off the lot. That I can get behind. The sweet spot with purchasing a used car is on that probably 4-6 years old since it’s had the time to depreciate but won’t have a ton of miles just yet (ideally).

    Also, never lease. That’s pretty clear to me. Thanks for sharing!

  2. Thanks for stopping by Lance. I agree with all those points. And you are right if you can get a 0% option then buying isn’t bad, but not many people can. And you still have a car payment. I personally like to buy about 2-3 years old because the bulk of the depreciation happens in that 2 year period. It still goes down just not as fast. But I would love to be able to just buy my cars outright. Until then I will drive the wheels off of mine. Cheers.

  3. You bring up a ton of great points! SOO many people also do similar things with houses where they’ll get a house that’s out of their realistic budget, but then they’ll amortize the loan out longer so the monthly payment seems lower. Ultimately, I think you should try to buy the car outright or be able to pay it off in 12 months if you take advantage of a 0% financing deal

    1. I think you are exactly right. And a 0% finance deal would be nice. I wonder, however, how many can actually get that, particularly with the rise of subprime auto loans. The rise in interest rates might put that out of reach. Thanks for stopping by.

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