Before you decide on the color, size and model of your next car, you might want to back up a little bit. Buying a car is a serious commitment, and the first question you should ask yourself is: “What can I afford?”
Even if you keep a detailed budget, it’s not always easy to figure out how a car payment will affect you financially. Luckily, there are formulas and organizations to help you out.
With the average auto loan of new cars at $26,691 and the country’s total auto loan debt at more than $783 billion, now is as important a time as ever to make sure you don’t overextend yourself and end up owing more than you can pay. Here are four steps that should drive your next car purchase:
1. Understand your financial picture in full.
You should first assess your overall financial obligations to know how much you can shell out for car payments each month.
John Ohmer, the CEO and founder of YellowBrickRoad Financial Advisors in San Francisco, suggests that your total debt payments be no greater than 28 percent of your gross income. This means that if your existing debt payments—everything from student loans to mortgage payments to credit card bills—equal 20 percent of your gross monthly income, your car payment should account for no more than 8 percent of your monthly income.
Lenders, of course, will allow for a higher debt-to-income ratio, Ohmer says, but their main concern is whether you are technically able to pay them back. They don’t care if you have enough money to lead a comfortable life.
If your total debt payments go above 28 percent, Ohmer says, you may start to feel stress. “That auto loan payment starts constricting your ability to do something else. Maybe you don’t take the holiday you want to take.”
The portion of your income spent on debt obligations will also depend on your own comfort level. The financial experts at Consumer Reports recommend not devoting more than 36 percent of your gross monthly income to debt obligations, which would give you more wiggle room than Ohmer’s formula. In any case, you need to know your stress level so that you can stay below it.
2. Calculate your monthly payment.
When eyeing a car, you’ll want to calculate how much you’ll need to pay monthly. To do that, you should take several factors into consideration: the proposed purchase price, the down payment, and the interest and terms of the loan. Bankrate.com has an auto calculator to help you determine how much you’ll need to pay each month.
If you find a low interest rate, which is not too difficult in today’s market, you could buy a more expensive model. Rate tables at Bankrate.com will give you a general idea of current interest rates.
Additionally, providing a healthy down payment will inch you closer to your dream car while keeping you below your spending limit. That said, automobiles—unlike most homes—constantly decrease in value, so buying a nice car is more of an indulgence than an investment.
3. Consider the additional costs.
The yearly cost of owning and operating an average sedan increased nearly 2 percent in 2012, according to AAA. These costs aren’t part of the purchase price, but they can have just as much of an impact on your financial health.
“There’s the cost to acquire the car and the cost to own the car—just like a home—and one ought to carefully consider both of these,” Ohmer says.
Before signing on the dotted line, consider these other car-related costs:
Gas: Gasoline is a huge cost for motorists, and it’s the one they feel most directly. The national average price for regular unleaded gas was $3.67 per gallon on July 22, according to AAA, which was the third highest average on record for the calendar day. There’s no expectation gas prices will decline anytime soon.
Maintenance and repair: Does the car come with free service or an extended warranty? This is an area of potential savings, and many automakers now offer free maintenance.
Insurance rates: Be aware that many factors, including the model and year of car, the driver and the driving record, will affect your auto insurance rate.
4. Pick your car.
In the end, there are many reasons to choose a car, such as comfort, style and safety. Just make sure that you start the process with this question: What car can I afford?