I’ll admit it: budgeting and figuring out financing is probably the least sexy and fun part of shopping for a car. That being said, it’s one of the most important parts and the first thing you should do before anything else. There’s no reason to fall in love with the perfect vehicle if you’re just going to discover that it’s far beyond what you can reasonably afford to pay. Figuring out what your budget looks like can mean the difference between shopping at a buy here pay here dealership or being able to pick and choose from numerous dealers and brands.
First Steps: Budgeting Basics
To get things started, let’s go over some budgeting basics and rules that you can live by as you figure out how to meet your needs. There are a number of different guides out there for figuring out your budget, but one of the simplest ones to work within is called a 50/30/20 budget. With this type of budget, you should account for spending 50% of the money you make on things you need (rent/mortgage, food, utilities, and transportation), 30% of your spending should go to things you want (that shiny new pair of shoes, going out for drinks Saturday night, etc), and 20% of your money should go toward savings. Not everyone can perfectly meet these numbers, but it gives you a good guideline to shoot for.
Within that 50% of your budget that goes towards things you need, a lot of experts recommend that your transportation budget should account for no more than 20% of your total spending (that’s 20% of what you make, not 20% of the aforementioned 50%–just to be clear), with half of that going toward your car payment. In other words, your monthly car payment shouldn’t be more than 10% of what you make—the other half of your transportation budget is for gas, insurance, and maintenance to keep your vehicle running. You can see that we’ve gotten down to a pretty small percentage for your car payment, which can make things tricky.
Let’s say you live in Michigan—just as an example—where the average annual salary is $49,259; let’s round that up to $50k to keep things simple. We’ll also assume this is take-home after taxes, also to keep things simple. Someone making $50k a year brings home about $4,160 each month; looking at our budgeting from earlier, 10% of that is $416. So, to stick to the budget we’ve planned on, our example person needs to find a car with a monthly payment that’s no more than about $400 with a little wiggle room. Great—except the average monthly car payment in the US right now is $729; even used cars have an average payment of $528—that’s not great for our example person.
Next: How Do You Figure Out Car Payments?
Now, let’s talk about car payments and how you can get a sense of what you’ll need to pay for your next vehicle. First off, you’ll need to understand a few different factors. For starters, you need to know the price of the vehicle you’re interested in—not just the starting MSRP but the price for a particular trim you want with the features you’re looking for. The best way to go about this is to look at dealerships near you to get actual prices, not the baseline pricing you’ll find on manufacturer websites.
With that information, you’ll want to look at an online auto loan or car payment calculator. Yes, you can figure this out yourself with some scratch paper, but it’s much easier to just use a good online tool. Now, you need to know what kind of interest rate you can expect to deal with on any car loan you’ll get, and this largely depends on your credit score. That’s a whole separate issue that we don’t have time to get into today, but just know that the better your credit score, the better terms you can get on a loan, including a lower interest rate. You’ll also need to know what sales tax looks like in your state and what sorts of extra fees you can expect.
Finally, factor in anything you can do to bring down the amount that you’ll need to borrow for your next vehicle. Two main things can help you out: a down payment and a trade-in you have toward your vehicle. These two things decrease how much you need to borrow, which has a significant impact on the amount you pay back. Finally, consider how long you want to repay the loan—longer terms lower your monthly payments but cost you more in interest over time.
Example One:
Let’s say you want a vehicle that costs $30,000; we’ll say you live in a state with 8% sales tax, and we’ll ignore other fees to keep things simple. For this example, we’ll say you have nothing for a down payment or trade-in and that you’re offered a loan with a 12% interest rate and a 60-month or five-year term for repayment. In this case, you’d be looking at monthly payments of about $667; over the course of the loan, you’d pay more than $10k in interest beyond paying off the original $30,000.
Example Two:
Now, let’s say you want the same vehicle, same sales tax, and same terms for your loan. But this time, you have $5,000 to use as a down payment, and you have a vehicle the dealership will give you $8,000 for as a trade-in. This decreases the amount you need to borrow from the full value above to just $17,000. Now, you’re looking at payments of only $378 per month and about $5,690 in total interest over the same 60-month period. That’s the advantage of making a down payment and having a vehicle you can use as a trade-in.
Thirdly, Don’t Only Focus On Your Monthly Payment
Understanding your monthly budget and how much you can afford for your next vehicle is great; it’s also a dangerous trap. Car dealerships will sometimes try to get you to focus solely on monthly payments as a way to talk you into a more expensive vehicle with a longer financing term. Consider this: let’s say you’ve figured out you can reasonably afford $700 each month for a car payment, and you’re dead-set on sticking to that. Great. But here’s the trap…
Using the same 8% sales tax and 12% interest rate, you could get a vehicle with a $26,500 loan that you pay off in 48 months, making payments of just under $700 each month—during that time, you’d pay about $7,000 in interest. Or, only focusing on payments, you could get a vehicle with a $40,000 loan and pay it off over 84 months, still making payments of about $700 each month. Let’s say you have $10k combined from a down payment and a trade-in. That means these two loans could get you either a $36k car or a $50k vehicle with incredible luxury options that are hard to pass up—and you’re still making the same payment. The trap is that over the course of that second loan, the one that goes for seven years, you’ll pay more than $19k in interest! That’s money you’re effectively throwing away, and the fancy $50k car ends up costing you more than $70k before all is said and done!
Now Get a Great Vehicle You Can Afford
I hope this has been helpful as you can see that you need to take a big-picture approach when looking at your finances, budget, and what you can afford for a monthly car payment. It can be tempting to get that fancy ride that you don’t think you can afford when the salesperson starts showing you how it fits your monthly budget—but you’ll be paying it off for the better part of a decade. A balanced solution that fits your monthly budget while also getting you a great long-term price is the best way to go and something future-you will thank now-you for. Just take the time to figure things out before going to any dealer so you’re ready to tell them what you can pay, how long you’ll accept a loan for, and then stick firmly to your budget.
