If you plan to get an auto loan, you need to first figure out the answer to the question “How much car can I afford?” Figure out how much you can afford to pay by calculating your monthly budget. Do this before you set foot in a dealer’s shiny showroom where they might try to seduce you into buying and financing more car than you can afford.
How Much of My Paycheck Should Go Toward Car Loan Payments?
You’ll hear different advice about how much you should allocate for your car loan payments when you finance a car. Twenty percent of your take-home pay is acceptable, according to Edmunds.com, a popular resource for automotive information. A sensible, conservative approach is to allocate no more than ten percent of your gross income — that is, your income before taxes — to monthly principal, interest and insurance payments
When deciding how much of your hard-earned money to spend on financing a car, don’t stretch your budget too thin to pay for a depreciating asset. If you lose your job, divorce, incur medical expenses or get hit with other unexpected major expenses, you’re still generally stuck with your auto loan payments. Keep in mind that an auto loan is a secured debt which means if you don’t make your car payments, the bank can repossess your vehicle — leaving you with no car.
A popular approach to budgeting car expenses is the 20/4/10 rule:
- Pay at least 20% as a down payment. The more you pay upfront, the less you’ll need to borrow and the less it will cost you in the long run.
- Limit financing to four years. Beware of car dealers who try to distract you with a low monthly car payment that will run for five or even six years — which might be longer than you own the car.
- Allocate a maximum of 10% of your gross income to your monthly car payment. Include the monthly principal and interest amounts as well as the insurance premium.
Keep in mind that your monthly payment isn’t your only automotive expense. You should also factor into your monthly budget adequate amounts for car-related expenses including:
- Routine maintenance
- Highway tolls
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If you live in an urban area, you might also get the occasional parking or traffic ticket, so you might want to factor that expense in, too.
Don’t limit yourself to the car financing options that a dealer offers. Check with banks and credit unions for the best car loans. You’ll generally get the most favorable loan terms if you have good credit.
Ultimately, you might find that you can’t finance a car without pushing your monthly budget into the stress zone — where your debt-to-income or DTI ratio is uncomfortably high. If that’s the case, consider buying a less expensive car or perhaps paying cash for a used car in good condition.
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