How To Know If You Can Afford a Car

These days, cars are deeply expensive, a continuing ripple effect from the pandemic’s global microchip shortage that limited the supply of new cars. The shortage puts pressure on the used car market, driving up prices for all cars, new and used.

While costs for new cars and higher-priced used cars are improving, older used cars remain the most difficult to buy, according to Kelly Blue Book. That creates another hardship for people who want a lower-priced car.

If you’re in the market for a new or used car, here are six things to help you figure out how much car you can afford in this tricky auto era.

The 20/4/10 Rule

Use the 20/4/10 rule as a guideline to avoid getting upside down financially. If you’re able to afford more, then great.

• 20 — If possible, pay at least 20% of the car's purchase price as a down payment to avoid being underwater on your loan.
• 4 — If you can, finance the car with a loan term of four years or less. This helps you avoid paying excessive interest over an extended period.
• 10 — Aim to keep your transportation costs total (car loan payment, insurance, maintenance, fuel, and registration fees) to around 10% of your monthly income.

Weigh All of Your Financial Goals

If you want to buy a newer, more expensive car, consider your other savings priorities to help you decide if it’s really a top priority. There’s no wrong answer here. If you know what’s important to you, and you understand how one decision impacts another, you should be able to make a good choice for your unique situation.

1. Define your goals. Buying a house? Saving for a new baby? Starting a graduate degree?
2. Prioritize those goals. If, for example, buying a house in the next five years is your top goal, it may make sense to spend less on a car to save more for a house down payment. On the other hand, if you already have a house and kids, maybe the safety features of a new car are a high priority.
3. Determine how one goal impacts other goals. Think about the ripple effects of buying an expensive new car. How are your other goals affected and are they more important than an expensive car?

Optimum Down Payment

A 20% down payment is ideal if you can afford it, and of course, you can put down more if the budget allows. Hopefully, the down payment is money you’ve saved and doesn’t come from funds needed to pay other bills or obligations. The most important consideration is whether the monthly loan payment works for your budget.

In a best-case budget scenario, car expenses don’t exceed 10-15% of your monthly income. If the down payment and monthly expenses are too much to handle, you may want to look for a more affordable vehicle.

Additional Costs of Car Ownership

Other related costs can catch you off-guard. Here are a few other possible costs to keep in mind beyond your monthly payment.

• Depreciation. The value of your car goes down sharply in the first few years, though some cars hold their value better than others. But generally, if you need to sell it, you likely won’t get close to the original sales price.
• Insurance. Beyond the basic insurance premium, additional costs include deductibles, coverage for accidents or comprehensive claims, and potential insurance rate increases after accidents.
• Regular maintenance like oil changes, tire rotations, and unexpected repairs add up. Older cars often mean higher maintenance costs.
• Fuel costs vary according to the car's fuel efficiency, gas prices in your area, and driving habits.
• Taxes and registration vary by city and state and can be significant, especially for new cars.
• Tires need to be replaced periodically, which can be a big expense depending on the type of tires your car requires. Seasonal snow tires add another cost.
• Parking and tolls.
• Emissions and safety testing. Some regions require regular emissions and safety testing, which might involve fees.
• Roadside assistance services.

Is it Better to Lease or Buy?

For some people, leasing a car makes more sense than buying, while for others, buying is a better choice. It’s all about how you’ll be using the car.

Personal preferences

A few things to think about include whether you prefer long-term ownership over driving a new car every few years, as well as your annual average mileage, resale value of the car, and future plans.

For example, mileage: if you tend to have a high annual mileage rate, purchasing might be a better option to avoid mileage penalties. Another consideration is resale: if you plan on owning a car that holds its value, you may be better off purchasing.

On the other hand, if your near future includes having kids, maybe you want to lease now and upgrade to a larger car when babies arrive. Think about what your future includes.

Consider your credit score worthiness as well. Leasing may require a higher credit score.

Budget considerations

Then there are the budget impacts of leasing and buying, both short-term and long-term. In the short-term, leasing is generally more favorable, while buying is often better in the long-term. It’s important to look at the whole picture.

Short-term budget impacts of leasing versus buying:

• When leasing, monthly payments are typically lower than loan payments because you're essentially paying for the car's depreciation during the lease term.
• Leasing usually involves lower upfront costs because leases usually require a smaller down payment or even no down payment.
• Maintenance costs may be lower because leased cars are typically under warranty.

On the flipside, purchasing a car typically involves higher monthly payments, depending on what you buy, a higher down payment, and higher insurance and maintenance costs.

However, the long-term budget impact is also important to think about as you weigh vehicle costs against other savings goals. Long-term leasing involves some downsides.

Long-term impact of leasing versus buying:

• At the end of the lease, you don't own the car, and you have no equity. You have nothing to sell to put toward an upgrade.
• Leases typically come with mileage limits and exceeding them can result in extra charges.
• Wear and tear fees: you could be charged for excessive wear and tear.
• Continuous payments: After each lease term, you'll need to start a new lease whether you keep driving the same car or switch to a different car. Since you never own the car outright, there’s never a point where you’re free from monthly car payments.
• Exiting the lease term early can result in penalties.

When you purchase a car, on the other hand, the car becomes yours.

• Over time, as you pay off the loan, you'll build equity in the car, and eventually, you'll own it outright.
• You’re not subject to mileage limits.
• You can sell or trade in the car when you no longer want it, recouping some of your investment.
• You have the freedom to modify the vehicle however you like.
• Once the loan is paid off, you eliminate the monthly payment from your budget—whereas leasing means you have continuous lease payments.

Influence of Your Credit Score

A good credit score plays a significant role in determining favorable car loan terms. Lenders use credit scores to assess the level of risk associated with lending money. A higher credit score generally leads to better loan terms, lower interest rates, and more favorable borrowing conditions. Here’s how to improve it:

• Check your credit reports with the three credit reporting bureaus, Experian, TransUnion, and Equifax, and clear any errors. You can request the reports at AnnualCreditReport.com.
• Always pay your bills on time.
• Reduce your credit card and loan balances if you can. Lower credit utilization and lower overall debt totals will both help your credit score.
• Avoid opening new credit accounts.
• Don’t close old accounts if possible. Having older accounts that you’ve kept in good standing is beneficial. Once you close an account, the average age of your credit accounts goes down, which can hurt your score. It’s better to leave a card open and not use it.

If lack of savings or poor credit are holding you back from buying a car, consider working with a trained financial counselor. The counselors at MMI can help you find ways to reduce debt, improve your credit, and start building toward your most important financial goals.