There are few things more seductive than a new car. It’s shiny, it’s beautiful, you’ve always wanted it, and nothing would make you feel better than signing on the dotted line and driving that beauty away. The dealer even makes it sound affordable!
Before you reach for the pen, stop and think. Taking on a large long-term car loan can cripple you financially for years. Transportation is important, but it’s also important to know how much car you can afford to buy.
Let’s explore what you need to know to determine how much you can spend on your car without harming your finances.
Why It’s Important to Keep Car Costs Down
Cars are one of the highest expenses in the typical consumer’s budget. In 2021, the average household spent $10,509 on auto expenses. That’s 16% of their total spending and the second-highest line item after housing.
To put that into perspective, that’s about $875 per month. If you started investing that into the S&P 500 at age 21 instead of spending it on a car, you’d have around $400,000 saved by age 40, assuming an average real return of 6.65%.
It might be unrealistic to forego a car altogether, but even marginally reducing your monthly auto expenses leads to significant savings.
Cutting your spending by 25% from $875 to $656 frees up $219. Putting that into the S&P 500 each month starting at age 21 would still mean an extra $100,000 by age 40.
As you can see, cars massively impact your ability to save and invest money. Buying more car than you can afford can make it difficult to invest or even save an emergency fund.
It can also leave you with bills you can’t pay and no savings to fall back on. That can even lead to repossession, which can crush your credit and leave you with no way to get around.
Unfortunately, because we expect to spend hundreds of dollars on car payments each month, we often don’t realize how much a car costs us.
If you want to improve your financial position, car expenses are one of the primary budget items you need to get under control.
How Much Should You Spend on a Car?
Fortunately, figuring out how much you can afford to spend on a car is pretty straightforward. The best way is to work backward from your income, savings, and budget. Here’s how to do that for the initial and recurring costs of having a car.
Car costs fall into two categories: upfront costs and recurring costs. You need to consider both.
How Much You Should Spend on a Car Upfront
Whether you use financing to buy your next car or not, you’ll probably spend a lot of cash upfront. It’ll go toward expenses like your down payment, sales taxes, and registration costs.
Generally, the initial outlay should be low enough to avoid dipping into your emergency fund, which should be at least three to six months of expenses.
⚠️ If you spend your emergency savings to buy a car, you put yourself in a precarious financial position. Not only are you eroding your financial safety net, but you’re also increasing your fixed expenses. If something goes wrong, you’d have to go into debt to meet your obligations…
Say you have $20,000 in cash savings and want to get a car. If you estimate your monthly expenses after buying the vehicle to be $3,000, you should keep between $9,000 and $18,000 in cash. That puts your budget for upfront costs between $2,000 and $11,000, depending on your risk tolerance.
Many dealers will offer financing with no down payment. This may seem like a good deal, but it usually isn’t, especially when it’s combined with a long loan term.
Cars depreciate fast, and with no down payment and a longer loan term, you will almost certainly owe more than your car is worth for much of your loan term. That means extra insurance costs and big problems if you need to sell or refinance your car.
How Much You Should Spend on Recurring Car Costs
General financial wisdom recommends spending no more than 10% to 20% of your take-home pay on transportation.
👉 For example: If you earn $4,000 each month after taxes, you’d want to keep your monthly auto expenses between $400 and $800.
Personally, I’d strongly suggest that you stick to the bottom of that range or lower, if possible. You typically need to save at least 15% to 20% of your income to retire in 40 years, assuming you invest your savings in a healthy portfolio and plan to withdraw the standard 4% per year in retirement.
If you start saving late or want to retire early, you’ll need to save even more than that to reach your goals. Spending 20% of your paycheck on your car makes that challenging.
Only you know how much you can spend on a car each month and hit your desired savings rate. If you want to allocate 10% more of your monthly budget to your car, that’s fine. Just know that you’ll have to make sacrifices elsewhere to make up for it.
💡 Pro Tip: Test your ability to afford a car by putting the amount you plan to spend each month into a savings account for a few months. If that negatively impacts your quality of life or you struggle to make the payment, lower your estimated car budget.
How to Calculate the Cost of Buying a Car
To decide whether you can afford to buy a given car, you need to compare the upfront and recurring costs of doing so to your budget. Whether you’re paying for the vehicle outright or using an auto loan, follow these steps to estimate those amounts.
1. Choose Your Down Payment
If you’re buying your car with cash, you can note your car’s purchase price and skip this step. If you’re going to finance your car, you need to decide the percentage of your vehicle’s value you want to put down upfront.
Down payments typically aren’t required when you finance a car. However, they’re a good idea to provide anyway since they can significantly reduce the interest you accrue over the life of your auto loan.
Using a five-year auto loan with a 5% interest rate to purchase a $42,500 car would cost you $5,622 in interest over the life of the loan. A 20% down payment of $8,500 would reduce that to $4,497, saving you $1,125
2. Estimate Your Other Upfront Costs
In addition to the down payment on your vehicle, you may also incur the following expenses when you first purchase your car:
- Sales taxes: States and localities often impose a tax on transactions that involve the sale of tangible goods, including cars. Rates vary depending on where you live, but you can usually expect to pay between 5% and 10% of your car’s price.
- Dealership fees: If you buy your vehicle from a dealer, you’ll incur miscellaneous fees, such as documentation fees, destination charges, and advertising fees. These vary between states but can be as much as 8% to 10% of your car price.
- Title and registration fees: Even if you purchase your vehicle from a private party, you’ll usually still need to pay some fees to process the paperwork for transferring ownership. These also depend on where you live and can be anywhere from $50 to several hundred dollars.
If you already have a car and plan to buy your next one from a dealer, you can trade in your previous vehicle to reduce your purchase price by its value. That also reduces your sales taxes in many states, as you usually only have to pay them on the difference.
3. Determine Your Interest Rate
When you finance a car, your auto loan is your highest recurring vehicle cost. As a result, you’ll need an accurate estimate of your prospective monthly payment to determine whether you can afford to buy a car.
The first step is to find your interest rate, which primarily depends on your credit score. Here’s what you can expect to receive in 2023:
| Category | Score Range | New car average interest rate |
Used car average interest rate |
|---|---|---|---|
| Deep subprime | 300-500 | 13.42% | 20.62% |
| Subprime | 501-600 | 10.79% | 17.46% |
| Near prime | 601-660 | 8.12% | 12.08% |
| Prime | 661-780 | 5.82% | 7.83% |
| Super prime | 781-850 | 4.75% | 5.99% |
Of course, these are only averages, and you may receive offers for much higher rates from some dealerships. Because they outsource these loans to third-party lenders, they often mark up the rate so they can pocket the difference.
To protect yourself against this scam, get prequalified before going to a dealership. That’ll help you assess the reasonableness of each offer and give you more leverage to negotiate with dealers.
📗 Learn More: The Great Auto Loan Scam: How Not to Be a Victim
4. Set Your Repayment Term
The second primary variable in calculating your monthly loan payment is the length of your repayment term. They’re usually available in 12-month increments and range from 24 to 84 months.
Extending your repayment term can lower your monthly payment, and many car dealers will try to offer you a long-term auto loan to convince you that a more expensive car fits your budget. However, setting a lengthier term raises your total interest costs and increases the chance of being upside down on your car loan.
The lengthiest repayment term you should reasonably accept is 60 months. If you can’t afford the payment for a car with a loan that long, then you probably can’t afford the car.
📗 Learn More: Are Long-Term Auto Loans Worth It?
5. Estimate Your Other Recurring Costs
Your loan payments will be your highest recurring expense when you finance a car, but you’ll also incur several other significant costs. Here are the ones you should factor into your calculations:
- Gas: Use your vehicle’s miles per gallon (MPG) and your local gas prices to project how much you’ll spend on gas each month at your expected driving levels. Consider adding a 20% cushion, as these variables all fluctuate.
- Parking: Depending on where you live, you may have to pay monthly fees to park your car. Apartment complexes often collect fees for parking in their garages, while cities may charge you for street-parking permits.
- Insurance: All states except New Hampshire require auto insurance. Rates depend on several factors, including age, location, driving record, and vehicle type. Get personalized estimates from several providers to estimate your costs.
- Maintenance: Maintenance costs also vary between vehicles. You can use tools like Repair Pal to get a breakdown of what you can expect for various makes and models.
With that, you should have everything you need to estimate the upfront and recurring costs of buying a car. To get help putting it all together, use our auto loan calculator to do some of the math.
Should You Lease a Car Instead?
The financially responsible way to get a car is to pay cash for a reliable vehicle in your budget with low maintenance costs and good gas mileage, then drive it into the ground. Unfortunately, many people are reluctant to do this.
I won’t speculate on the merits of their reasons here. Just know that if you don’t take that approach, the question of buying or leasing a car becomes more difficult to answer. In fact, a comprehensive discussion is beyond the scope of this article.
However, buying is generally more beneficial the longer you plan to hold onto your vehicle. Leasing becomes more attractive if you plan to switch out your car for a new one on a regular basis.
However, leasing means committing yourself to shell out hundreds of dollars or more each month to maintain access to a car. It’s a luxury, not a sound financial decision. I wouldn’t recommend it unless you’re so wealthy that you have money to burn.
Avoid Stretching Your Budget For a Car
Having a healthy savings rate is the best thing you can do for your finances. The wider the gap between your income and expenses, the faster you’ll be able to progress toward your financial goals, whether that’s paying off debt or saving for retirement.
Since transportation expenses are the highest line item in the typical consumer’s budget after housing, keeping them as low as possible is one of the most effective ways to boost your savings rate.
Do yourself a favor and buy a car you can easily afford. If you’re not sure if you can afford the car you’re looking at, consider a cheaper one or a used car.
An affordable car can give you a significant financial advantage over most households and help you avoid the nightmare of missing your car payments, damaging your credit, and having your vehicle repossessed.
