How Much Should You Spend On A New Car?

For many of us, the second largest purchase you make after a home is you car. However, many people spend way more than the recommended amount when purchasing their vehicle. Overpaying on a new car can set you back years on your journey to financial freedom. And taking out a long car loan in order to buy more car than you afford can restrict your budget & investing for years.

You should strive to have the lowest car payment and price that is reasonable. The maximum recommended monthly car payment is 10% of your take-home income. But how much car you can afford is much more than that.

Key Points – New Car Spending:

• Auto loan payments should be a maximum of 10% of your monthly income
• When you own a car, you should budget for expenses like repairs, insurance, registration, and maintenance
• New car prices are approaching $47,000 at the end of 2021 according to Kelley Blue Book

Guidelines On New Car Spending

Overspending on a new car is one of the most common missteps people make while trying to reach financial security.

There are a few general guidelines to use when car shopping. However, the best answer is to spend ‘as little as you can’ when looking at purchasing a car.

When you start adding on features, they quickly add up and can lead to significantly higher care cost. Sure that sunroof would be nice, but it can add $1,000-$3,000 to the price of the car. Is that worth it when you live in an area that is cold for half the year?

The general recommendations around new cars are to spend less than:

• 10% of your monthly salary on the car loan payment
• 30% of your annual salary on the purchase price of the car
• 20% of your monthly salary on total car expenses (loan, gas, insurance, maintenance, tax, etc.)
• 20/4/10 Rule – 20% down with 4 years of financing and 10% of your income as the max monthly payment

The above guidelines are starting points. If you are a high earner, it doesn’t mean you should buy an expensive car though. The less you spend on the car is more money for you to save & invest to reach financial security sooner.

Monthly Car Payment Under 10% of Take Home Pay

When budgeting for a car, one recommendation is keeping your auto loan payment under 10% of your after-tax take home monthly pay. This guideline is good in that it ensures your monthly budget isn’t stretched too tight due to car payments.

If you have $5,000 a month in after-tax pay, this would result in a $500 car loan payment. By keeping your loan at this level, you are leaving enough room in your budget for adequate savings and investing.

However, the downside of this rule is that it doesn’t take into account the length of the car loan. For example, a $30,000 car loan at a 4.5% APR results in:

• $685 monthly payment for a 4 year loan (48 months), but
• $372 monthly payment for a 8 year loan (96 months)

The longer the loan term, the more in total payments you will pay and interest cost. In the above example, you would pay $2,850 interest for a total cost of $32,850 on a 4 year loan. But by extending out the loan for 8 years you pay $5,800 in interest and $35,800 in total payments. That is an additional $2,950 in interest costs due to the longer loan period. (see an easy, free online car loan calculator here)

Paying extra interest is a drag on your wealth growth. One of the largest benefits of having a strong credit score is getting the lowest available APRs on your loans. But you can undo all the benefits of your high credit score by choosing a long loan period.

Additionally, many people will choose the longest loan length to try to maximize the amount of car they purchase. If you are only looking at your monthly payment, you could justify buying a car that is twice as expensive by choosing longer loans. Therefore, we need to also look at the 2nd guideline which puts a price limit on new cars.

Purchase Price Of A New Car Under 30% Of Your Gross Annual Salary

The 30% cap on the purchase price of a car ensures you aren’t buying more car than you can afford by spreading out payments. This calculation is easy to do, take your gross (pre-tax) salary and make sure the price of the car is below 30% of it.

If you make $60,000 a year, you should look to buy a car under $18,000. If you make $100,000 a year, you can buy a car up to $30,000.

This number may seem low when a Tesla can run you over $100k new, meaning you need to make over $300k to buy one. But if you want a fancy luxury car, you should use that as motivation to increase your earnings. Buying a more expensive car than you should is a sure-fire way to crash on your trip to financial independence.

One way to lower your purchase price is to buy a used car instead of a new car. You can often purchase a few year old used car for significantly less than a brand new version of the car. However, used cars often come with higher maintenance and upkeep costs. To make sure we aren’t purchasing an expensive used car, you need to also look at your total car expenses.

Total Car Expense Under 20% Of Your Monthly After-Tax Pay

If you live in an area that has a high car ownership cost, you can end up spending a lot more than expected. Everyone should also use the rule to limit your total car expenses to “20% of your monthly after-tax pay”. This rule is very similar to the total car loan being 10% of after-tax income. However, you include all costs, not just the loan payment. Total car expenses include all the ancillary expenses of car ownership like gas, insurance, taxes, repairs, parking, etc.

To calculate your total car ownership expense you need to include:

• Auto Loan Payment: Your monthly payment on your car loan
• Car Insurance Premiums: Drivers need to carry liability insurance in almost every state and some states have significantly higher car insurance costs. Additionally, this will vary based on your age, location, coverage options, driving history, expected number of miles driven, and type of car. The average insurance premium in 2021 was roughly $1,500.
• Maintenance Costs: All cars require regular service and maintenance for oil changes, tire changes & rotations, new brakes, etc. The general guidance is $0.10 per mile in maintenance cost. If you drive the average 12,000 miles a year this is $1,200 in additional expenses.
• Gas/Charging: Your car needs fuel to operate. The Bureau of Labor Statistics estimates the average person spends $2,000 a year on gas in 2019. With gas prices being higher, the number is likely much larger now. Charging your car at home isn’t free and adds to your monthly electric bill as well.
• Property Tax: Many areas have a property tax on car owners. If you live in one of these areas, you can look up the mill rate to find the expected taxes. Mill rates are $1 tax for every $1,000 of value. If you buy a $30,000 car and your town has a mill rate of 0.025, it means that you will pay $750 in taxes on your vehicle.
• Parking: Many cities have limited parking and require you to pay for parking. Parking costs can run hundreds to thousands of dollars a month depending on your location.
• Repairs & Replacement Parts: Things on cars break and need to be repaired or replaced. Parts can range from a few dollars to 5-figures.

In the above examples you have: $1,500 in insurance, $1,200 in maintenance, $2,000 in gas, $750 in taxes, and any parking or other expenses. That is $5,450 in costs on top of your auto loan payment. This is over $450 a month on average additional expenses.

If you had a $500 auto loan payment, that means you are almost doubling it with the $450 of additional expenses. This all-in expense number should be less than 20% of your after-tax take home pay.

In short, if you live in an area with a high cost for car ownership, you are already paying a high portion of your budget for transportation expense. Therefore, you should aim for a lower car loan payment than someone living in an area with a low cost of car ownership.

20/4/10 Rule For Car Buying

The 20/4/10 Rule is a separate rule that tries to be more encompassing by requiring a certain down payment and loan length. The 20/4/10 rule of car buying states:

• 20% down payment on your car purchase
• 4 year maximum car loan length
• 10% of your monthly income in car payments

[Professor B.T. Effer Note – The 20/4/10 rule traditionally is for 10% of your gross income, however, we recommend doing it on after-tax income. Taxes can be one of the biggest expenses you pay in your budget and people have very different tax rates.

For example, a single person may have a much higher tax rate than a married person with multiple kids. If you use gross income they would get the same result despite very different take home after-tax pay]

The benefits of the 20/4/10 rule is it prevents you from extending out your loan to purchase more car than you should and it requires you to make a large down payment of 20% when you buy the car. Paying a higher down payment and opting for a short loan period, you will decrease the interest you pay on the loan. Additionally, the 20% down payment makes you do some saving up front and can help you keep the purchase price lower.

How Do These Car Buying Rules Compare?

The 4 guidelines above result in similar results when using the same 4-year car loan as the 20/4/10 rule. If we assume an annual after-tax biweekly pay check of $2,500 you get $5,000 a month for your budget and $65,000 annual after-tax salary

We assume a 4 year (48 month) auto loan for 4.5% APR for this comparison.

• Car Loan 10% of Monthly Salary: The monthly salary of $5,000 results in a max car loan payment of $500. You can take out a $22,000 car loan at 4.5% for a $500 monthly payment
• Total Car Expense 20% of Monthly Salary: As shown in the above section, the additional costs we came up with was $450 per year. 20% of $5,000 is $1,000 in total car expenses, meaning you would have $550 for your auto loan payment. A $550 auto loan payment corresponds with a $24,000 loan.
• Purchase Price 30% of Annual Salary: A $65,000 annual salary corresponds with a $19,500 purchase price which results in a $450 monthly auto payment.
• 20/4/10 Rule: You get 10% of your monthly salary as a car payment like the 10% rule. And since all the examples are using a 4 year loan the result is very similar to the 10% rule. The only difference is you are putting down a 20% payment.

The Final Word – How Much Should You Pay For A New Car

New car buying is one of the easiest ways to dig yourself into a financial hole. As a publicly visible display of wealth, many people get caught up in a race to ‘keep up with the Jones”. However, getting a car outside your budget can derail you from your financial goals.

You now know 4 different guidelines to use when determining your new car purchase. The vehicle should:

• have a loan payment Less than 10% of your monthly earnings
• have a total monthly cost of ownership less than 20% of your monthly earnings
• have a purchase price less than 30% of your annual earnings
• The 20/4/10 rule gives you guideline for how much down payment and term of loan to use

At the end of the day though, saving money on a high cost item like a car can have a huge impact on your financials. These guidelines are there to give you guardrails and a number to be below. If you find a car that fits your needs that is below the above thresholds, that is beneficial.

Frequently Asked Questions (FAQs)