Cars are a necessity for many of us, and it may be difficult to live without them in some cases.
But buying too much car or a car you can’t afford can slow down your wealth building.
In this post, we’ll cover 3 rules you can use to determine how much car you can afford and some other factors to consider before buying a car.
3 Rules of Thumbs For Car Affordability
1. 20-4-10 Rule
This is one of the most popular rules for calculating car affordability.
There are 3 parts to the rule
1st Part: Down Payment:
The first part of the rule says you should put at least 20 percent of the car value down as down payment. Obviously, the more you can put down, the lower your monthly payment and the total interest over the life of the loan will be.
It is estimated that a car can lose up to 20 percent of its value by the end of the first year. And given that a higher portion of the first year’s payments goes toward the interest, a lower down payment may mean you’re owing more than the car is worth by the end of the year.
2nd Part: Loan Term:
The second part of the rule says the term of the car loan should not be more than 4 years.
If you have to take a loan for 6 – 8 years just so you can fit the monthly payments into your budget, you simply can’t afford the car. Be honest with yourself.
A lower term means you will pay lower interest over the term of the loan. But to be honest, with rates near zero these days, the interest savings may not be that high.
More importantly, a car can be worth as little as 50 percent of its original price after just four years. Do you still want to be carrying a high loan balance at that time?
3rd Part: Monthly Payment:
This part of the rule brings the cost of the car closer to home – what you pay monthly. It says the total car payment, including insurance, should not be more than 10 percent of your monthly gross income.
For example, you should keep your interest, principal, and insurance payments below $500 if your monthly gross income is $5,000.
Here’s why this is a good idea:
The lower your car payments, the more money you have for your other monthly obligations and saving towards your goals.
- It’s easy to understand and calculate
- Higher down payment means lower monthly payments, lower interest paid over the life of the loan, and a lower debt load overall
- It puts the focus on paying off the loan fast by capping the term at four years
- Gross Income: the rule uses your gross income to calculate how much your monthly car payments should be. But after deducting your payroll tax, the take home pay will be quite different from your gross.
- Ignores your other monthly obligations: such as housing, groceries, debt repayments (see below) and savings. If you live in a big city, it is not uncommon for the housing cost to be over 30 percent of your monthly income. Add groceries, child-care, and your savings to this, and you may be left with little wiggle room.
- It does not consider your total Debt load: How much you can afford in car payments should be considered as part of a larger assessment of your other debt obligations. Do you have credit card debt, student loans or other types of loans? How much does the repayments come to every month?
2. Dave Ramsey’s 50% of Annual Income Rule
According to Dave Ramsey, the value of all your vehicles should not be more than 50 percent of your annual income.
His reason is simple:
Cars are a depreciating asset and it make no sense, financially, to put too much money into buying an asset that could lose 50 percent of its value in five years.
Dave Ramsey is also not a fan of buying or leasing a new car in general. He preaches buying an affordable used car with cash. This way, you’re letting someone else pay for that initial depreciation in the value of new cars.
The challenge with this rule is this: it does not account for monthly payments and the other costs of owning a car, such as insurance, gas, maintenance and so on.
Let’s consider an Ontario resident earning $100,000. Using this rule, he can afford a car of $50,000. We’ll assume he’s getting a 4-year loan at 0% financing and a 20 percent down payment. His monthly take home pay is about $6,000 and car payments of $833.
That’s almost 14 percent already, before considering the other costs of car ownership.
3. Sam Dogen’s 1/10th Rule
This car buying rule was developed by Sam Dogen of Financial Samurai. It takes a similar approach to Dave Ramsey’s rule – It is also based on your annual income but more stringent.
The rule states that the value of your car should not be more than a tenth of your gross annual income.
According to a study compiled autoTrader, the average price for new cars, including cars, SUVs and Trucks, was $40,490 in 2019.
The median after-tax income in Canada was $61,400 in 2018, with a wide disparity depending on the household composition: singles at $30,700 and families at $91,600.
If we gross up these values to get the before tax median income, calculate a tenth of the result and compare the figure to the average price of new cars in Canada, it is clear that Canadians are spending too much on cars. At least, according to this rule.
I like this rule because it forces you to allocate a relatively small amount to a depreciating asset. Though the rule does not consider what your total car ownership cost will be per month, it should be relatively low.
The Problem With Rules Of Thumb
These rules, like many other rules of thumb, are meant to provide a general guidance and not necessarily an exact figure to work with. They are a convenient way to quickly make a reasonable estimation of how much car anyone can afford.
But no two people or households are alike. There will be differences in financial goals, current savings and investment, car buying pattern and so on. That is why it’s called personal finance.
By all means, start with the rules. The range of figures you get from the exercise is a good starting point. But go beyond that by considering your own specific circumstances – financial and non-financial.
For example, consider two individuals with the same annual income of $80,000. One has a net worth above $1 million while the other is just starting his career and has little savings. The first may decide to take some liberties and buy a $40,000 car, but it’ll be difficult to justify the same decision, financial wise, by the second.
What does this mean for you?
It’s simple. Don’t treat these rules like they are laws of physics that will always hold.
How Much Car You Can Afford: Other Factors
Most of the rules discussed above attempt to recommend an amount based on your income alone. The 20/4/10 rule goes a step further by considering the loan term (maximum of 4 years) and down payment (minimum of 20 per cent).
As mentioned earlier, this is a good starting point. To get a figure that reflects your personal situation, here are some more important things to consider
- Why Do You Need The Car
Do you see a car as a necessity? Something that can take you from one place to another reliably.
You see cars as objects of luxury to show class and status, and have to be changed every few years to reflect the latest trends?
- Your Net Worth
Net worth is a better indicator of how good your finances are than just your income. It is simply the difference between your assets and liabilities. But it tells a better story about how you have managed money in the past, your spending habits, your saving and investment, the assets you have acquired and their quality and so on.
If you’re still in the accumulation stage, there are more important things than buying an expensive car.
- Car Buying Pattern
If you’re someone that needs to change your car every 3 years, it’ll be hard to justify even buying a car that’s 10 percent of your annual salary. On the hand, if you tend to buy a reliable car and drive it for as long as possible, say 10+ years, then buying a more expensive car than be justified as long as it does not affect your other monthly obligations especially your financial goals.
- Opportunity Cost Of The Car
Cars are a wasting asset. Whether you pay cash upfront for a car or make monthly payments over some years, there’s an opportunity cost for the cash outflow.
The money could have gone towards saving for a house, retirement, children’s education and many other financial goals. You should be asking yourself how much you’re saving by not buying that car.
Of course, this assumes that you’re disciplined enough to actually invest the money you saved by not buying a car, or buying a cheaper one, in an earning asset.
So before you buy a $30,000 car that would have lost most of it’s value after 5 years, you need to consider how that money would have compounded in the same period if you invested it in the stock market, and how that will get you closer to your financial goals.
Alternatives To Buying Another Car
Here are a few other options to consider before buying another car:
- Stick with your old car
- Take public transit: Bus, trains and so on
- Use ride-hailing services like Uber or Lyft
- Sign up for car-sharing or peer-to-peer sharing services: Turo and Zipcar
- Use Rental cars
Before buying that new car, ask yourself these questions:
- How much am I saving by not buying a new car?
- Have I considered all my options?
- Can I justify the new car considering my current net worth?
The more money you have invested in things that go down in value, the longer it will take to achieve financial freedom.
Keep this in mind when thinking about how much car you can afford.