Since the beginning of the global COVID-19 pandemic in early 2020, economies around the world have suffered, as have the bank balances and financial prospects of many ordinary people. With their working lives being transferred home instead of at the office, many families decided to give up one car to save themselves the expense and for the year of 2020 car sales took a serious nosedive.
In 2021, however, demand for new cars has surged to levels that took the industry by surprise. Demand has been so great, it’s even causing and perpetuating a global shortage of semiconductors that is pushing up new car delivery times as global car production suffers under the chip shortage and now growing strains on the supply chain.
Beyond the availability of cars, however, is the question of affordability. The tighter supply of brand-new cars has sent demand for used cars skyrocketing. Buying used or new, the same question applies - just how much car can I afford? This is the core question of today’s blog.
Buying a Car - Typical Costs
It’s essential that people don’t confuse buying or financing a car with being the true cost of a car. There are many more costs involved when buying, registering, insuring, maintaining and running a car on the public roads. In this section, we’ll give a quick breakdown of those costs and what they are.
Nerdwallet.com revealed in one article that for a vehicle that is driven 15,000 miles a year --- which is just above the US average of 14,200 miles annually --- the full ownership costs were $9,561 per year, or $797 a month. That was a number revealed in 2020 and it was calculated by AAA. What are the typical costs that go to make up this huge number?
First, Charges When Buying
Before we even get into running costs, there are the costs involved in getting the car into your name in the first place:
- Purchase price or monthly car loan payment or monthly lease payment
- Interest payments (if financing)
- Destination charge
- Sales tax
- Delivery fee (if buying online)
Fueling your car is obviously a big and important regular expense. If it’s a gasoline car you have to think about how much you spend on filling up every week or month. If it’s an electric car, you have to think about how much you spend charging at home, as well as how much you spend charging the car at public charging stations.
Some EV owners are lucky to be enjoying a period of free public charging at the moment, which is sometimes a perk of the car brand they choose. But if they charge at home, then it costs.
EV costs are hard to track because providers differ widely, but gas prices are well tracked on platforms like fueleconomy.gov .
Registration, Taxes, Inspection and Whatnot
Getting your car legally recognized by your state each year also costs money in the form of annual inspections, registration and/or property taxes. Some states such as Arizona are very cheap, where registration costs just $8, but other states like Oregon charge as much as $636 for new cars, and up to $306 for renewals. Florida isn’t far behind with its new-vehicle registration fee of $225.
Maintenance is harder to gauge because there is regular maintenance that any car would need: oil and filter changes, tire rotation, new air filter, etc. But there’s also maintenance and repair work that could come about by accident: damaged bumpers, broken tail lights, etc.
According to AAA, the average annual cost of maintenance and tires comes to about $112.50 each month. That’s when you average the bigger ticket items that come later with the cheaper things you deal with at the start.
According to bankrate.com, the average cost of insurance each year for full coverage --- liability-only would be cheaper --- is $1,674, which comes to $139.50 per month. Many factors impact your total insurance costs, so of course this one is hard to comment on for every individual. The 40-something in an executive sedan with 23 years’ driving experience and no accident or police history will get cheaper insurance than an 18-year-old boy and his new hot hatch with 2.0L turbocharged engine.
How Much Car Can I Afford? Calculator Estimate
The first method and probably the most reliable is to use a “How Much Can I Afford” calculator online. These are free to use and there are often calculators attached to various car-buying sites that work in conjunction with the platform’s own inventory to ensure that you get a number that reflects how much you can afford if you buy with them.
Using the Carvana calculator as an example , it asks you to input your estimated monthly payment. This refers to the amount you can pay each month. On top of that, it asks for your credit rating, your loan period and what downpayment you can afford.
The good thing about using this system is that you can just be totally honest with what you know you could pay monthly, how much you’re willing to put as a down payment and how long you want to repay and you will get a straight-up solid figure to use as a ceiling when budgeting for a new car. If you stay within that ceiling, you’ll be able to get the terms that you want.
For instance, using the Carvana calculator, let’s say we know for sure we can pay $400 a month, and we have $2000 saved in cash to use as a deposit on a car. Our credit rating is solid, but not quite “Good” so we put it at “Average” which is about 630.
We want to repay the loan over 4 years, because we think going longer just means too much interest. With this data put into the system, Carvana tells me I can afford a budget of $17,783.
Problems with USing “How Much Can I Afford” Calculator
The issue surrounding the calculator is that, as we touched on, the calculator is tied to the specific platform you are browsing on, like Carvana. That budget wouldn’t necessarily apply if I then went onto another platform to check their inventory.
In that sense, it means we have to buy from where we get the best calculator result, but for many that might not be a big problem.
How Much Car Can I Afford? Based on Salary
When using your salary as an estimation, arguably the most established method is to use the 20/4/10 rule. It’s not fool-proof and there are some who criticize it as an inaccurate estimate, but it remains tried-and-tested by many. Let’s take a closer look at the 20/4/10 rule.
What is the 20/4/10 Rule?
This refers to three quantities that you should use as a guideline to help you tell for sure if a new car that you are interested in is actually affordable for you. It does this by asking buyers to calculate the three quantities that check whether with your existing funds and future income you’ll be able to manage a 4-year car finance deal. Let’s take a closer look at each number in turn:
The “20” in the 20/4/10 rule refers to the amount of deposit that you should be able to put down on a car purchase. There’s no difference between new and used cars when using this rule. It applies the same way to both new and pre-owned cars. The rule says that your deposit or down payment on the car should be at least 20 percent.
The figure of 20 percent is not an arbitrary number. It’s designed to help you stay out of negative equity --- your car finance going “underwater” as it’s also known --- when paying off your car loan. Most cars will lose up to 20 percent of their total value after the first year. It’s invariably the hardest year of depreciation for any car model.
By paying 20 percent of the new car price up front, followed by 12 months of regular payments, you can be sure that the depreciated value of your car does not fall below what you’ve already paid for it.
The smaller your deposit, the greater the risk of negative equity. The risk also goes up if you pay the loan back over a longer period of time making the monthly payments smaller. A deposit of 20 percent is essentially a guarantee that you’ll always stay ahead of the negative equity curve.
The next number is 4, and this refers to the number of years you should aim to repay the car financing in full, regardless of it being a new or pre-owned car purchase. Car financing is more generous than ever, with some offering loans for up to 84 months (7 years). The period of 48 months (4 years) is seen as the best balance for affordability.
Long loan periods, as we mentioned above, can mean lower payments but also a greater risk of going into negative equity with the car. A very short period like 24 months means you could pay it off much faster and with lower interest, but the monthly payments will be much higher as a result. Therefore, 4 is a nice balance of getting the car paid off quickly while remaining affordable.
Paying off the loan in 4 years also means that if you’re buying a new car, you only have 1 year of driving where most cars’ manufacturer warranty has expired, which reduces the risk of having to pay out big on maintenance bills.
The final number in the list is 10, and this refers to the percentage of your gross income that your monthly car payment should never exceed. So, the rule is that when you take the car payment plus monthly insurance rate and other driving expenses and add it together, it hopefully won’t come to more than 10 percent of your gross income.
If it’s at 10 percent or less, that means you shouldn’t have any problem meeting your monthly commitment to paying the loan off.
For instance, if your gross monthly income is $6000.
This means that your car loan payment, insurance payment, gasoline costs and maintenance costs shouldn’t exceed $600 a month in total. The “10” part of the rule is where there is the most debate about the 20/4/10 rule, which we will deal with in more detail below.
Problems with 20/4/10 Rule
There is some debate over the validity of the 20/4/10 rule, especially the latter “10.” What’s the source of this debate? First of all, there is an issue of whether the 10 should refer to gross or net income.
If it refers to gross income, then some argue that it falls short of providing an accurate assessment, because there are so many things that will drain your gross income as well such as taxes, utility bills --- expenses that you can’t avoid. If you remove 10 percent of the gross before you account for other unavoidable expenses, how can we be really sure that we can afford it?
Another criticism of the “10” part of the rule is leveled at the fact that it’s just too little compared to the typical price people will pay even for fairly simple cars, never mind getting into luxury brands. Using Carvana’s auto loan calculator , a car costing $25,000 for someone with a good credit score of 680 will cost $476 a month at least when we follow 20/4/10.
At $25,000, we’re not talking luxury brands, nor are we talking high specifications, and that $476 is for a “Good” credit rating. Lower the rating to Average (630) and it goes up to $506. Is the kind of person who is interested in a $25,000 car earning more than $5,000 a month?
Conclusion: Check and then Recheck the Numbers
When you’re wondering how much car you can afford, there can’t be enough times that you check and recheck your numbers to be sure. It’s crucial that you take every cost element into account and don’t overlook anything. Many people struggling with car-related debt do so because they failed to comprehend the real cost of ownership before they took on an expensive loan or lease.
Be meticulous in your calculations, but always stick to the conservative side of the scale and underestimate how much you can afford. It’s better to underestimate than overestimate. At least when you underestimate, the only “downside” is that you more easily afford the car you just bought.