Your dream car and the car that you can realistically afford can be two totally different things. If you are paying cash, then your car choice may not be a complicated one. However, if financing is your only option then how to determine what you can afford for a car becomes a crucial undertaking.
Ideally, you should go for a car whose monthly payments do not exceed what your income can handle. Your calculations also have to factor in the extra costs that go into buying a car as well as the operational expenses that you will encounter on a daily basis.
What’s an affordable car? How do you go about the calculations? Let’s find out.
Breaking Down your Car Budget
Apart from the price listed on a car, there are other costs that you should consider. These are expenses that you find out on your own and plan for; the car salesman won’t reveal them to you!
Up-sells and Cross-sells: The dealer will try to increase the displayed price, a strategy known as upselling. You will be enticed with features like extra body kits, chrome wheels, warranties, etc. Another common trick is being led to buy a different and more expensive brand or model; cross-selling. Avoid these extra costs by sticking to your first choice.
Dealership Fees: There will be registration fees, sales tax, and documentation fees. These are for you to bargain with the dealership. Such fees can drive the price up by around 10%.
Ownership Expenses: Once you own the car, other expenses start: insurance, maintenance, repairs, annual registration fees, depreciation and the like.
Gas is another major ownership expense that most people neglect to factor when making a purchase. Let’s use a Toyota Prius, a favorite for first-time owners as an example; it goes for around $20k plus a possible 5k to cover the other costs.
The car consumes about 44 miles per gallon. Data from Federal Highway Administration show that on average a driver covers 13,476 miles per year. This translates to around $907 per year at $2.96 per gallon (13,476 miles x $2.96 / 44 mpg).
True Cost of Owning a Car
After you have calculated the expected cost of the car you are looking for (plus the extra costs), your budget starts to take shape. Using the above example, you are looking at around $25,000 for a new car with a 5-year (60months) car loan. However, for the true cost of owning you need to factor gas expenses for the loan duration;
True cost of owning = Purchase + Other costs + Gas = $20,000 + $5000 + ($907 x 5) = $29,535
Can your Income Sustain the Monthly Payments?
With car financing, you will be repaying the loan on a monthly basis. So what’s the optimal percent of your monthly income that should go to the car? There is no specific answer to this since budgeting depends on your priorities.
Most experts, however, recommend that transportation should cost 10-15% of your net pay. This follows a 50/30/20 rule where 50% of your income goes to living needs, 30% to flexible spending and 20% to investments and other long-term financial goals. Your car is included in the ‘living needs’ category with the remainder of the 50% going to mortgage and utilities.
It’s upon you to ensure that your car loan repayments fall within the 10-15% range. For the Prius, the monthly cost will be around $493 (the total cost of owning/ 60 months). Hence your take-home pay should be at least $3290 for you to afford this car.
Monthly income= $493 x 100/15 = $3290 (assuming 15% of your pay is the car budget)
Before you walk into a car dealership, do your homework on all the costs that will go into owning a car: Make use of free online calculators to get a rough idea of which car you can afford and understand all costs that may come with other deals like trade-ins. Lastly, negotiate your car loan for cheap rates, keep in mind that a longer loan term could mean a lower resale value by the time you have paid off the loan due to depreciation.