Rules of thumb are great: they give you an idea where to start thinking. They’re not perfect; of course not. There are always exceptions and variables and special situations. But those are truly unique situations. For most people, rules of thumb are useful tools.
I know how hard it is to buy a car within your spending ability. I bought a (new-to-me) car on Friday. When I started shopping last month, I had a budget of $15,000. As I shopped and shopped, that budget kept going up and up. (Goodness, cars are expensive.) First, I nudged it up to $20,000, then $25,000. Next thing I know, I’m looking at $30,000 cars! Thankfully, I came to my senses and found something that will be quite suitable for our family, back very close to our original planned amount. Is it perfect? No. Is it affordable? Yes, and frankly, that’s a heck of a lot more important to me.
There are many, many rules of thumb about how much car you can afford. This is an area where it is useful to have some clear-cut guidance, because cars are one of the two places where people make their biggest financial mistakes. About 95% of the people I talk to who are in financial trouble are in a pickle because they bought a car they can’t afford or they bought a house they can’t afford. And it’s sad, because both can be avoided with some research and careful consideration. And sometimes that careful consideration includes checking your purchase against the various rules of thumb you’ll see discussed different places. If your car meets any of these guidelines, then it is probably a reasonable purchase. If it meets all of these guidelines, you can feel pretty confident that you’re not doing something dumb. Check out these options and see how they resonate with you:
My Friend Rob’s Five Months Pay Rule
My friend Rob is pretty smart, and he doesn’t mess around with nonsense. His car-buying rule is your total loan amount must be less than five times your monthly base pay. That means if your monthly base pay is $3,126, then your car loan shouldn’t be more than $15,630. Want to buy a car more than the amount you can borrow? Save up a large enough amount that your loan comes down under that level. Can’t afford to save up that money? Then you can’t afford the car. Period.
As Rob says, “I’m sorry if that won’t let you buy a Mustang GT, but that’s what you can afford.”
I honestly think this is the best rule out there. It’s super-simple, it allows folks to buy whatever they want as long as they can save up enough money, and it makes sense.
The 10% Rule
A common rule of thumb is that the total of all your transportation costs should be less than 10% of your monthly income. Unfortunately, that’s a dream for many people, especially as the cost of insurance and gasoline continues to rise. My family barely meets this rule, and we have no car payments, and none of our teens have their driver’s licenses yet. As soon as one child gets her driver’s license, we’ll be over 10% of our budget on transportation.
That’s doesn’t mean it’s not a useful idea, though. If 10% is the dream, then we can all agree that 30% is unreasonable, right?
Dave Ramsey’s Half Your Income Rule
Dave Ramsey is good at making one-size-fits-all rules about all sorts of things. I don’t agree with all of them, but his rule on cars is pretty good. Dave Ramsey says that the total value of everything you own with a motor should be less than half your annual income. This includes cars, trucks, motorcycles, RVs, ATVs, and anything else you can imagine.
Kate’s Rule #1
I actually have two rules of car buying. The first one is actually more about depreciation and down payments than the price of the car itself: Don’t borrow for a car if you couldn’t afford to turn around and sell it at any time and pay off the loan. In different words, don’t borrow in a way that you’re underwater when you buy the car, or that you’ll be underwater at any point through the loan.
This rule sounds more complicated than it is. Basically, I’m saying that the amount of your down payment needs to be as much as the loss of value that will happen as soon as you buy the car. Don’t have a very big down payment? Then you better buy a used car that is known to hold its value.
Being underwater on a car is a terrible situation. Somehow, we’ve come to find it normal when folks say, “I can’t sell it, I’m underwater.” This is not normal.
Once again, this rule isn’t about how much car you can buy. It’s about how much loan you can take. I’m sure you know that in a perfect world, I would rather than no one ever borrow money to buy a car. But if you are in a situation where you think you can justify a loan, be smart. Please be smart.
Kate’s Rule #2
If you’re planning ahead for your next car purchase, start making your estimated loan payment to yourself now. Put that money in a bank account designated for your car purchase. If you can make that “loan payment” to yourself every single month, on time, without a problem, for a full year, then you’re probably in a good place to afford that loan. If it gives you any trouble, or you ever have to dip into that money for anything, or you miss a month, then you can’t afford the loan.
The best thing about this plan is that you’ll also be building up money to put towards your next car purchase. We’ve been doing this for three years, and we had enough money to pay for our new car in cash – no loan necessary! (There was some insurance money, too, just so you don’t think I’m completely bragging.) That’s the ideal that we’re all working towards, and I was finally able to do it without having to raid other savings accounts.
As you can see, there are plenty of ways to evaluate whether you can afford to purchase a car. In a perfect world, we’d all be able to save up in advance and pay cash for modest, used cars. In reality, sometimes we are in accidents or have babies or move across continents. But just because you can’t pay cash doesn’t mean that you can’t be super-smart and buy a vehicle that will fit your family and your wallet. Use these rules of thumb to see what will, and will not, work for you!