I’m a Financial Planner: Don’t Spend More Than 15% of Your Income on a Car Payment
The average American spends $725 on their monthly payment for a new vehicle, according to Experian’s data from earlier this year. This is a $75 monthly increase from the previous year. While used vehicles tend to have a lower monthly payment, the average person still spends roughly $516 a month on their used auto loan.
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When it comes to determining how much you should be spending on your monthly car payment, there’s no one-size-fits-all answer. Factors like your monthly take-home pay, living expenses, financial goals and other financial responsibilities or obligations — like debts — should all be taken into account. At the same time, you should also consider the true cost of vehicle ownership — beyond the monthly payment.
Keeping that in mind, GOBankingRates spoke with financial experts Jeff Rose and Robbie Morris about calculating and managing your maximum monthly car payment. Here’s what they said.
Follow the 20/4/7 Rule
“My favorite rule of thumb for buying a new car is the 20/4/7 rule,” said Robbie Morris, financial planner at Roots Financial Planning. “I use it as a guideline with clients so that they can make a decision without breaking the bank.”
Here’s what the 20/4/7 rule looks like, according to Morris: “Put at least 20% down of the initial purchase price. Finance an auto loan for no more than 4 years (48 months). Make sure that monthly payments add up to less than 7% of your gross income.”
You can use a calculator to estimate your auto payment before you buy. Say, for example, your gross annual income is $70,000. Your monthly payment should be no more than $408.
Currently, the average interest rate on a new car loan is 6.58%. If you get a 48-month loan with that interest rate, that means you can afford a car with a purchase price of roughly $22,000, with a 20% down payment of $4,500.
Keep in mind that you may have other expenses to consider, such as the state’s sales tax, vehicle title, registration and other fees. If any of the fees that add to your total monthly payment increase it to beyond 7% of your gross income, you may need to go with a cheaper vehicle.
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Keep Your Car Payment Under 15% of Your Net Income
While the 20/4/7 rule is a great way to keep your monthly car payments reasonable, it might not work for everyone. Another common rule of thumb when calculating your maximum car payment is to keep it to no more than 15% of your monthly take-home pay.
“A widely accepted rule is that your car payment should not exceed 15% of your monthly take-home pay,” said Jeff Rose, a certified financial planner and founder of Good Financial Cents.
If you earn $70,000 a year after taxes, that breaks down to roughly $5,833 a month. With the 15% rule, you can spend $875 on your monthly car payment — including interest and all other fees.
However, this might be a bit high for some people. That’s why “it’s crucial to evaluate your budget holistically to determine what is reasonable for your specific situation,” said Rose.
Depending on your circumstances, you might find it easier to determine your monthly payment based on your net income. Or you might be better off going with a cheaper vehicle with a lower payment altogether.
Calculating Your Auto Payment When You Have Multiple Cars
The majority of households have at least one car, with some people having two, three or even more vehicles. Before taking on a new car payment, consider how much you’re already paying for vehicular financing.
If your other vehicles are fully paid-off, this calculation should be pretty straightforward. But if you have other auto loans, add them all together to determine whether a new payment is reasonable or not. It’s also important to consider your other debts when figuring out affordability.
“Households considering an additional car payment should first ensure their total debt — including mortgage, credit cards and existing car payments — does not exceed 36% of their total income,” said Rose.
Be prepared to save up money for a down payment, too. Just like when you buy a house, it’s a good idea to have a down payment for a vehicle, as this can help offset the purchase price, lower your monthly payment amount, and potentially reduce total interest charges.
“With the average down payment being $6,780 for new and $3,921 for used cars, ensuring you have a substantial down payment and a clear understanding of the total cost of ownership — including insurance, which averages about $168 per month — is vital before taking on additional financial commitments,” said Rose.
Account for Total Ownership Costs
The cost of owning a vehicle isn’t only about the monthly payment amount, which is why you should factor in other expenses, such as vehicular maintenance and gas, when calculating your maximum monthly payment amount.
“When calculating a realistic car payment, consider not only the monthly payment but also insurance, maintenance, fuel and unexpected repair costs. For instance, the average cost of car insurance is about $168 per month,” said Rose.
Before purchasing a vehicle, shop around for different insurance companies and get a free quote or estimate from each one. This can help you compare prices and find the best possible price. Keep in mind that more expensive vehicles or certain makes and models may have higher insurance premiums.
“Also, consider the loan term, as longer terms mean lower monthly payments but a higher cost overall,” said Rose. “For example, the average loan term for new cars is 69.44 months, and 68.01 months for used cars.”
Another major factor is the interest rate. The higher the interest rate, the higher your monthly payments — especially if you have a shorter term loan. While getting a longer repayment term can lower your monthly payments, it can also significantly increase your total interest charges.
You may also be responsible for additional fees, such as registration fees, licensing and taxes. For any annual fees, break them down into their estimated monthly costs by dividing them by 12. Then, tack that amount onto your monthly car payment to see if it’s still reasonable in your budget.
Bottom Line
Determining how much you should spend on your car payment isn’t as simple as just knowing the baseline monthly payment amount. You should also account for other debts you might have, as well as things like interest rates, insurance premiums, maintenance and repairs, and gas prices.
Take some time to consider your overall financial situation before taking on a new debt. And, if possible, save up some money first so you can pay a larger down payment — and get a smaller loan.
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This article originally appeared on GOBankingRates.com: I’m a Financial Planner: Don’t Spend More Than 15% of Your Income on a Car Payment
