Life is full of those little magical moments and buying a new car is one of them. Whether it’s a Lexus IS or a Honda Odyssey, you have envisioned it for years: the make, the model, the features and even the colour – especially the colour. But, one thing you probably haven’t considered much was how you were going to pay for it. After all, a car is a big chunk out of your piggy bank, so make sure it doesn’t cost more than you can afford.
Gross Income Ratio or Debt-to-Income Ratio
We all have financial obligations: mortgages, credit card bills, rent and other loans. But if you strategize properly, you can fit a car into the ebb and flow of your monthly payments. Start by measuring your gross income ratio.
Add up your revolving monthly debts, these consistent payments are a reliable marker, showing you how much you need in order to sustain your lifestyle. After that, divide the total by your gross monthly income. The result is the percentage of your gross income ratio or your debt-to-income ratio.
For example, if your revolving monthly debt is $600 and your monthly income is $3,000, then your gross income ratio is 20% (600/3,000=0.2). An affordable car that keeps your gross income ratio healthy should prevent it from exceeding 36% after including car payments, according to Consumer Reports. Meanwhile, MSN Auto suggests that owners should not exceed 15%.
Find a happy medium for yourself – since your debt should never exceed 75%. You’ve been warned.
Calculating these figures may feel like punishment, but it’s far from difficult – there are simple online calculators to help you figure out the important numbers.
Ideally, 20% has always been the conventional amount for the down payment (the initial payment, whether in cash and/or trade-in). But it is always better to put down as much as you can, just to avoid the fact that it might come back and bite you later.
That being said, many new owners are choosing to pay a lower down payment. One reason is because the interest rates a getting lower, people are not pressured to pay right away. Don’t follow the trend – car depletion is as inevitable as paying for insurance, gas and sales tax. Less only means you pay more in the long run.
There are many useful tools online, such as this down payment calculator that will help you decide how much you are willing to spend right from the get go.
If paying right away is not a viable option, you may consider taking a loan or leasing the vehicle and paying for it every month. But with monthly payment comes interest and that is just something that you’ll need to add on.
So, how much can you afford if you do choose to pay in monthly instalments for your car? Well, the financial experts at Consumer Reports did the math for us (well, at least, they found the formula). Begin by calculating 36% of your gross monthly income. Then add up your monthly payments including mortgages, credit card bills, etc. Subtract your debts from your gross monthly income. The difference is how much you can comfortably spend monthly on your new vehicle.
I’ll use smaller numbers for our example, lest I confuse you more. Let’s say your monthly income is $3,000. Then $1,090 is 36% of your gross monthly income (1,090/3,000=0.36). Now, let’s say you have $500 in monthly debt (1,090-500=590). If the math is correct, then you’ll know that you shouldn’t spend over $590 a month on your car.
Before you go off and purchase your vehicle, it is also important to note the extra fees that will undoubtedly cost you. Sales tax, registration fees and insurance premiums may cost you 10% more.
There are many things to consider when buying a car that might complicate the whole process and make you sick. If you want to forego all this math and simply want to recognize where you are in the car buying ladder understand the following rules:
The 50/50 Rule
If you make $40,000 a year, you can afford a $20,000 car. Half of what you make.
The 20/4/10 Rule
This rule suggests that you pay a 20% down payment, finance the vehicle for four years and never have the total expense of the car go over 10% of your gross income.