U.S. Markets open in 7 hrs 44 mins

How Much Can You Actually Afford to Spend on a Car?

Christy Bieber, The Motley Fool

For many Americans, a car is one of their biggest single purchases. And cars have gotten a lot more expensive in recent years. In fact, Experian reports loan balances across all loan types are at record highs, with the average loan payment on new vehicles now exceeding $550. 

As cars have grown more costly and Americans have taken out larger and longer loans to afford them, more vehicle owners have found themselves in debt trouble -- and auto loan delinquencies have hit record highs. 

All of this raises an important question: How much should we be spending on our cars? This guide will help you avoid borrowing more than you can comfortably repay.  

A woman holding keys to a car

Image Source: Getty Images

Your budget determines what you can afford

The single best way to decide what you can afford for a car is to make a detailed budget.

  • Figure out what your essential expenses are including housing and utilities.
  • Allow for nonessentials that you're almost sure to spend on, like dining out and entertainment.
  • Account for debt repayment (including paying extra toward any debt you have besides a mortgage and student loans) and aim to set aside at least 15% to 20% of your income to save for the future. 

Once you've budgeted for all these expenses, compare your total expenditures to your income to see how much you can afford to spend on your car. And you can't just account for your monthly loan payment -- you also need to think about gas, insurance, registration, and maintenance. 

You don't have to spend the maximum you can afford on a vehicle. If you find your budget allows you to spend $550 a month on a car payment, it's usually still smarter to opt for a cheaper used car with a lower monthly payment instead, and then allocate more money for extra investing or debt repayment.

If you find you don't have money left over after paying for other things you need and investing in your future, you'll need to make cuts elsewhere. Try not to cut your savings or debt repayments, as these are important expenditures for a secure financial future.  

Keep transportation costs at 15% of your income or less

While everyone should make a detailed budget, most people probably won't go through this entire process.

If you just want a shorthand estimate of how much you can spend on a car, most financial experts recommend transportation not exceed 15% of after-tax income. This 15% includes all car-ownership costs mentioned above, such as gas and maintenance. To make sure total transportation spending doesn't exceed the recommended 15%, your car payments should be capped at 10% of your take-home income. 

This means if you brought home $4,500 per month, your car payments would be absolutely no more than $450 per month. It still isn't a good idea to spend this much if you don't have to -- especially if you have lots of other financial goals you're working toward. But this is the maximum. 

Don't forget your down payment

There's another factor that goes into vehicle affordability: The amount of money you have to put down to drive your vehicle off the lot.

Reputable lenders typically require at least a 10% down payment. To buy a $30,000 car, you'd need $3,000 available to put down. And it's a good idea to put down more than the minimum -- especially on a new car, which depreciates quickly, losing as much as 20% of its value in the first year. So putting down at least 20% is advisable to offset this loss. 

If you don't put down enough money, you could end up underwater, which means you have negative equity because you owe more than the value of your vehicle. This is a big problem. If you need to sell your car, you won't get enough to pay off the car loan. And if you get into an accident or your car is stolen, your insurer won't reimburse you enough to pay off the loan.

You can buy gap insurance that will pay the difference between what you owe and the worth of the vehicle in case of an accident or theft. While this protects you from having to make loan payments on a destroyed car, it's another added cost. 

Don't focus solely on monthly payments

When considering car affordability, don't just focus on the monthly payment. You also need to consider the total cost of the loan.

You could make your monthly payments lower by stretching out repayment for a very long time, paying off your vehicle over 72 or 84 months. But you'll pay a ton of interest over time. Ending up with negative equity is more likely, too, since you're paying so little each month. 

Ideally, you should finance your car over three to five years at most, or for an even shorter time if you can. When you finance your car with a very short-term loan, you should be able to drive it for a long time after your loan is paid. You can save your car payments to pay cash for your next vehicle so you aren't stuck with a car loan all your life. 

Never buy a car that's not affordable

Now you have a clear idea of how to figure out how much you can spend on a car. Remember: Cars are depreciating assets, not investments, so spending the minimum necessary to get a safe and reliable car is usually a smart move. 


The Motley Fool has a disclosure policy.

This article was originally published on Fool.com