How much should you spend on a car? Probably not as much as you might think.
You can spend between 10 and 50 percent of your gross annual income on a car. That’s a big range, we know, so if we had to set a rule, it would be this:
Spend no more than 35 percent of your pre-tax annual income on a car.
Lower is better, but we recognize personal finance is personal. You might spend more only if you can securely pay cash for your vehicle and the kind of car you drive is important to you. You can explore how much car you can accord in our car affordability calculator below.
You can limit how much money you spend on your car by:
- Saving up and paying cash
- Buying used
If you do both of these things, you’ll save thousands of dollars compared to financing or leasing new vehicle.
That said, sometimes you need transportation before you have cash saved to buy a car. So there are some additional rules to consider when you get an auto loan.
Use our car affordability calculator to find out your maximum payment
Do you have a car to trade-in? How’s your credit? Have you been socking away money for a new car for years? These factors will affect how much of the car you’ll have to finance and how much you’ll have to pay in interest.
Use our car affordability calculator to see how your down payment, trade-in, and auto loan interest rates and terms affect the amount of car you can afford.
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The three rules of car financing
The rule of thumb when it comes to smart auto financing is the 20/4/10 ratio.
According to this rule, when buying a car, you should put down at least 20 percent, you should finance the car for no more than 4 years, and you should keep your monthly car payment (including your principal, interest, insurance, and other expenses) at or below 10 percent of your gross (i.e. pre-tax) monthly income.
Why is the 20/4/10 ratio smart? Here’s why:
1. Put at least 20 percent down
According to Edmunds, a new car loses 9 percent of its value the second you drive it off the lot. By the end of the first year, it’s lost 19 percent. (This is why buying used is the way to go.) If you put less than 20 percent down, you risk becoming underwater on your car loan—meaning you owe more on the car than it’s worth—almost immediately.
If you need to sell the car before the loan’s paid off, you’ll have to come up with the difference between the car’s value and the balance on your car loan. Ditto if you get into an accident and the car gets totaled.
2. The term of your car loan should be no more than four years
The longer the term of your loan, the more interest you pay. The longer your loan term, the longer you’ll have to meet your lender’s insurance requirements, which often means higher rates.
Plus, by the end of four years, your car will have lost a lot of its value, and you won’t want to still be paying it off.
Four years is the maximum most personal finance experts recommend. If you can swing paying off your car in three years, that’s even better. If you feel you absolutely must stretch your payments further, you could get a five year loan, but never longer.
3. Your total car payment (interest, principal, and insurance) should not exceed 10 percent of your gross income
Your dream car isn’t worth having if your monthly payments eat up all the extra room in your budget. Staying below 10 percent means you’ll have money to put toward other things—like an emergency fund, a down payment on a house, or a nice vacation.
It also means a change in circumstances—say, a pay cut or a job loss—won’t turn your new wheels into an albatross around your neck.
Rules aside, everyone’s situation is different
Yeah, yeah, you might be saying—but what if I need a car now? And not some junker, but a reliable one that’ll get me to work on time?
The 20/4/10 guideline is just that—a guideline. If you don’t have the cash for 20 percent down, and you can’t take the bus until you save some up, then put down less. (And please, please buy used!) If the only way to get your monthly payment down to 10 percent of your income is to extend the life of the loan, then do it. (But consider a cheaper car first!)
Also take advantage of our amazing resources to help you find the best car insurance for your individual needs. Get a quick quote from car insurance companies in your area using this tool:
Shop for car insurance
Keeping your monthly payment under 10 percent of your gross income is the most important thing. That’s what’s going to keep you from feeling pinched and stretched. Here are some of the top insurance providers on the market today that are operating in your local area. Find the policy that best suits your needs.
I also want to make a special note of an innovative car insurance company called Metromile, which sets your rates based on miles driven. This might be a good option for you to consider if you use your car sparingly and don’t want to worry too much about overpaying.
Related: Should You Ever Buy a Brand New Car
Related: Tips for Saving on Your Car Loan
How does the car affordability calculator work?
The above car affordability calculator uses a conservative but solid assumption about how much car you can afford. Whether you’re paying cash or financing, the purchase price of your car should be no more than 35 percent of your annual income. If you’re financing a car, the total…