How Much of Your Car Should You Finance?

Next to buying a home or funding your children's education, buying a car is the most expensive purchase you'll make. And car-related expenses, such as gas, maintenance and insurance, can take a big bite out of your wallet.

Kicking a few tires is only half the battle. Before you begin looking for a new car, you should know your limits and what you should be spending. Experts say you shouldn't spend more than 10 percent of your gross income on car expenses, which includes the cost of the car along with insurance, gas and maintenance.

Once you decide on a price range, you'll want to decide how much you can put down as a down payment and then negotiate the price of your car. Too many buyers accept long financing arrangements in order to minimize their down payment. If they decide to trade the car in the first year or so, they often find that they actually owe more on their car than it's worth. A good rule of thumb is never to finance more than 80 percent of the true cost---the dealer's invoice---of the car. At least 20 percent or more should be paid in cash or the equity of your trade.

Typically, after you negotiate the price of your car, the dealer will send you to their financing department. While it's true that dealers may have less restrictive credit requirements than banks, be wary of cut-rate financing deals that they frequently push. These attractive 3 percent interest rates may apply only to certain models or short-term loans of up to 12 months. Dealers make a lot of money on financing, even when it's done through the manufacturer.

Tip: Always negotiate the price before you reveal that you are thinking about dealer financing. If they know ahead of time that you plan to finance, they will frequently try to confuse the issue by giving you a lower rate on a higher price or a lower price at a higher finance rate.

If you do decide to finance through the car dealer, you can negotiate the interest rate. Dealerships usually have several loan sources, including local banks and the manufacturer's credit company. Each source sets their rates to the dealer.

It is important to investigate other sources for an auto loan (such as your bank or credit union) before you sign on the dotted line. Investigate your financing options and find out from banks or credit unions if they have any special deals right now.

Another possibility is a home equity loan or line of credit. With a home equity loan, you are borrowing against the value of your home. Not only are interest rates lower than those for auto dealer loans, but the interest on home equity loans and lines of credit are usually tax deductible. Proceed with caution, however, as you are putting your most valued asset on the line to purchase a depreciating asset that can be stolen.