If you think setting a new car budget is as simple as determining what you want your monthly payment to be, you could find yourself spending a lot more than you realize. The first step is to calculate your monthly car budget.
To start, add up your monthly bills and the amount you need to put into savings using Bankrate’s home budget calculator. A good rule of thumb is to spend no more than 20 percent of your monthly household income on all the cars in the household, but you may be able to spend more or less than that, depending on your other expenses.
Once you calculate your budget though, it’s not as simple as telling a dealer that amount when you are in the car-buying process.
Your car loan typically runs from three to six years, so a wide range of cars will be within your budget — depending on the length of your car loan. For example, say your monthly car budget is $500. At the current national averages for interest rates, that translates to a loan ranging from $16,500 for a three-year car loan to $32,000 over six years. That’s essentially the difference between a Toyota Matrix and a Lexus IS 250, if you are financing the total car price.
What’s wrong with getting a more expensive car for a longer car-loan term? From a financial perspective, there’s a lot that makes it a less savvy financial choice.
The first problem is the interest itself. At current national averages, you’ll spend $3,816.01 on a $32,000 car loan versus just $1,543.73 in interest for the $16,500 shorter-term car loan. That’s a difference of $2,272.28 — a substantial amount you could have spent on something else or put in savings.
Second, if you are the typical American driver, you aren’t going to keep your car until it’s paid off. This means you’ll still owe on your car loan when you are ready to buy a new car. If you decide to trade it in for a new car after three years, which is the typical length of time Americans own the same car, you’ll still owe $16,460.61 on your car loan. Yet, it’s quite possible that the car won’t be worth that much. A car that is financed over a longer term takes longer for payments toward the car loan’s principal to catch up to depreciation, or the point when you are no longer upside down in your car loan.
But let’s assume you will keep your car until it’s paid off. Still, your $500 monthly budget should be based on your total car costs, not just the monthly payment. That means you need to factor in costs for fuel, repairs, maintenance and car insurance. However, these costs tend to be higher on more expensive cars, primarily because they are more luxurious and therefore, more costly to insure, repair and maintain.
Using our earlier car example, ownership costs for a Toyota Matrix would be about $4,000 annually on average. Costs for a Lexus IS 250 would be about $4,950 annually on average. Again, that’s almost $1,000 more per year that you could put in your pocket.
So what’s wrong with deciding to go with the $500 monthly payment for six years and “treat yourself” to the $32,000 car? Nothing, if you don’t mind spending about $8,550 extra on the additional interest for the longer car-loan term and the additional cost of ownership. Of course, if you opted for the cheaper car and put that money aside, the $8,550 saved would sure make a nice down payment on your next car, wouldn’t it?
Ask the adviser