Thousand-dollar car payments are now a new normal, according to headlines, with more than 15 % of new vehicle buyers signing on for four-figure payments. A lot of these car payment posts are going viral on social media right now. How much is your car payment? Seventeen twenty? That’s crazy. In this article, we’re going to go over the rule for buying a car how much of a car you can afford
For this article, I actually have three different salary ranges that we’re going to discuss today. Someone who makes $40,000 a year, someone who makes $80,000 a year, and someone who makes $150,000 a year.
What The Car Dealership Does
A lot of car dealerships these days will try to convince you that you can afford more of a car than you actually can because they just stretch out the loan terms. The average car loan term right now is 69.7 months in America. And based on the data, if your credit score is lower, the more likely you are to take on an even longer car loan term. Not only that, car loan interest rates are getting higher, which means having a car payment these days is going to be a lot more expensive than it was before.
We’re going to cover a couple of car-buying rules today, as well as some ways to save money on car payments. We’ll also discuss whether financing or leasing a car is better. Lastly, I’ll give you some specific numbers on the three salary ranges that I mentioned before.
20 4 10 Rule for Buying A Car How
So let’s get started with this post and start with the first car-buying rule:
The 35% Rule
The 35% rule states that the most you should spend on a car is 35% of your gross annual income. That means if you make $40,000 per year, the most you should be spending on a car is $14,000. If you make $80,000 a year, the most your car should cost you is $28,000. And if you make $150,000 per year, your max car price should be $52,500.
In reality, the 35% car-buying rule is really aggressive and is mostly geared towards car enthusiasts or those who take enormous pride in owning a certain type of car. If you want a basic car that just takes you from point A to point B, then I would recommend being a bit more conservative and maybe making this rule the 20% rule or even the 25% rule in my opinion.
That doesn’t mean you’re just getting the most basic of basic cars, but you are getting a little bit of amenities. As long as you stay within this guideline, your car should be affordable.
If you take away anything from this article, just remember the 25% rule, not the 35%. That is slightly more aggressive.
Now, in the next section, we’re going to cover monthly payments of a car and what you should be aiming for in terms of those monthly payments. But I think that if you can focus on the actual purchase price of the car, that’s all that really matters at the end of the day.
The 20 4 10 Rule For Buying A Car
Now let’s actually talk about the next car buying rule which is about car affordability and your monthly payments.
The first part of this rule is that it recommends that you make a 20% down payment on your car. So if your car costs $30,000 out of the gate, that means it suggests that you should make at least a $6,000 down payment when you buy the car. The reason why they suggest 20% down is that it’ll be a lot easier to handle the loan over time when it comes to your payments. And having 20% on hand ensures that you are in a financially responsible position to actually buy this car.
If you finance 100% of a car, you could actually get into some trouble. So let me illustrate this with an example. Let’s say you buy a car for $25,000, and you finance the entire amount. After one year, the car depreciates in value by 20%, which is pretty common to have a car depreciate that much.
This means that your car is now worth $20,000 at the end of year one. So now if you want to sell the car, you could get $20,000 for your car after year one. But the thing is that you still might owe more than $20,000 on that loan. That means you’re underwater on the car itself, and that is a pretty common scenario with year one cars.
The 20% Down Payment
Making a 20% down payment lowers the amount that you actually have to finance. And it also helps you build equity in the car much quicker. This is also one of the biggest costs of cars, which is depreciation. I’ve actually mentioned this in my wealth killer article over here.
But basically, you’re constantly putting money into a depreciating asset when it comes to cars. So a really good option is to just buy a used car that is three to five years old, where most of the depreciation has been chipped away over time already.
The 4 Years
The four refers to the fact that you should not finance a car for more than four years. Four years is the suggested amount of time because it’s going to keep your monthly payments pretty manageable, as well as prioritize paying off the car before the car depreciates too much.
Also, if you push out your loan term to five, six, or even seven years, what actually happens over time is that you pay more money in interest.
You can see that on the left here if you are financing a car for four years that costs thirty thousand dollars, your total interest paid is $25.29.
Financing Over Six Years
However, if you finance it for six years, that total interest is now $38.29. So that’s over thirteen hundred dollars you were just throwing away to interest. I think that a problem that most people run into for countries that have auto loans is that the 20/4/10 rule is a really reasonable rule. But the fact is, is that many people don’t feel like it’s reasonable because it doesn’t get them the car that they really want. There’s a lot of societal pressures to actually buy a car that we can’t afford.
Look at those calculations above with a four-year term. You need to fork out $552 a month for the same car that costs $386 a months over six years. So you could have two people, one drives a really cool BMW, maybe they pay $550 a month, and the other person drives a 2022 Honda Civic which could cost them $550 a month. So the person with a BMW and the Honda Civic, they could be out at dinner talking about their car payments and it gets around that, “hey, they pay the same amount for their car.”
But the thing here is that the Honda Civic owner might feel bad about their choice because they’re paying $550 a month, but their term could be way shorter. Many people will opt for a longer car loan term because it allows them to get their status car or a car that’s out of their actual affordability budget. So, don’t fall for that.
The 10% Rule
The 10% rule refers to the fact that you should aim to keep your monthly car payments, including insurance and maintenance, to be less than 10% of your gross monthly income. Note that this does not include fuel costs, but you should always factor fuel costs into your overall budget anyway.
The table above shows incomes between forty thousand dollars and one hundred fifty thousand dollars per year and how much of a car payment you can afford. An easy rule of thumb is to simply take your gross annual salary and divide it by 120. That’ll actually get you the maximum monthly car payment that you can afford.
Looking at these salaries above, if you make $40,000 a year, you can afford a $333 car payment including maintenance and insurance. At $150,000 per year, it’ll be $1,250 per month that you can afford.
Now, just because you can afford something that might be a higher car payment than you expected, does that mean you should just max it out for the sake of maxing out? Probably not.
Always be prudent with what you can afford. If you’ve read the wealth killer article, you’ll know exactly why cars can really hurt in terms of compounding your wealth. The lower that you can spend on a car, the better because you can take that excess cash difference, you can invest it in stocks, you could save for a house. You could do so many more things with it than just putting it into a car payment.
Why 10%?
A common question is why is it 10%? Why is it not 15% or 20% of our gross monthly income? The purpose of this rule is that it leaves room for you in your budget for all the other things in life. We want to ensure that we have enough money to cover any other financial situations that come up, and so keeping your car payments less than 10% of your gross monthly income achieves this goal.
Buying or Leasing?
Another big question is whether should you buy or lease a car, and then if you are buying the car, should you finance it or should you pay it all in cash?
Let’s cover the leasing portion first. Leasing usually makes sense if you want a new car every three or four years or if you just want an overall lower monthly payment. If that’s the case, you are better off leasing than you are buying. Some other pros of leasing a car include a very low down payment, usually zero, warranty coverage, as well as if you are a small business owner, you could potentially write off some of the lease payments.
The cons include the fact that there are some mileage limits, so if you go over, you have to pay a little bit extra, and then at the end of three years, you have to return the car to the dealership or you have to just buy the car outright at the end of those three years.
In some situations, leasing a car might actually be beneficial for your financial situation.
But for most of us out there, if you want to own a car for a very long time, you want to buy the car because that’s going to make the most fiscal sense. So when it comes to buying a car, we can pay for it all in cash or we can finance it.
Which One Should We Do?
If you’re someone who values not having a car payment, some extra peace of mind, or perhaps you can get a discount for paying all in cash. Then perhaps that could be pretty interesting and might be for you.
Also, you might want to pay in all cash if you are not an investor. So I know that might kind of sound crazy on a personal, but there are plenty of people out there who do not invest. If the cash is just literally sitting in a bank account, not earning any interest, then you might as well put it towards a car because at least that way you’re not paying interest payments.
However, I do think that, if you’re reading from my blog, you’re probably an investor of some sort, and that’s why financing usually makes a little bit more sense here, and the reason is the opportunity cost of cash.
Pretend you paid $25,000 upfront for a brand-new car. That’s $25,000 that you do not have in your cash in your hands.
Opportunity Cost.
With that $25,000, you could be investing and compounding your wealth.
So let me give you an example. Let’s pretend you put 20% on a $25,000 car, that would still leave you with $20,000 in cash. If you took this $20,000 and invested it into the S&P 500, which averages around eight to ten percent per year, it could be worth $31,000 in five years.
Similarly, if you’re considering retirement, that money could become over two hundred and sixty-five thousand dollars over 30 years. Of course, no one really operates perfectly with opportunity cost decisions all the time, but hopefully, that example kind of illustrated why financing makes more sense than buying all in cash upfront.
Car Saving Tips
I want to share with you guys three tips on saving money when it comes to Car Saving
Tip 1: Call around for insurance.
The first tip is to call around and ask for different insurance rates. Basically, a lot of these insurance companies will compete with each other, and they always want to get you as a customer.
You’re more likely to get a really good deal if you just call a competitor. So let’s say you have AAA Insurance, you can call State Farm and be like, “Hey, what are your rates for this type of insurance?” and see if they can undercut AAA in that way. Oftentimes, it’s reported that people that switch car insurances can actually save between $100 and $200 extra per month.
Tip 2: Buy a used car
The second tip is something I already mentioned, which is buying a used car especially one that’s three years used because it still is pretty new. A three-year used car and most of the depreciation has been chipped away already.
Tip 3: Be mindful of maintenance cost
My third tip is to get a car that’s not too expensive to maintain. There is a calculator called the “true cost to own” calculator on edmins.com that is very, very helpful when it comes to this.
Sometimes a more luxurious car might cost you way more in maintenance and repairs than you actually might think.
So looking at this price for the 2017 BMW X5 versus the Toyota 4runner, you can see that the total cash price of the BMW is actually cheaper than the Toyota but ends up costing you over $20,000 more dollars over that five-year period to own because of maintenance, insurance, and repairs.
Final Thought
All right, after reading this article, you might feel a little bit sad about what you can actually afford when it comes to buying a car. The truth is Lifestyle Creep. Many people are punching way above their weight class when it comes to what they can afford.
The average price paid for a new vehicle in October of 2022 in the United States was $48,281. That means if we were using the more aggressive 35% rule, the average gross salary of all these people that are buying these cars should be $137,945 per year. That’s definitely far from the average salary in the United States, and the data shows that most people can’t afford their cars.
Let me know what it’s like for you if you’re in a different country, what your car payment looks like, or how much you pay for a car because I know that it can get actually quite more expensive in other parts of the world.
Hopefully, these guidelines helped you understand how much of a car you can actually afford.
