How much is too much to spend on a car?
The Federal Reserve Bank of New York just released some startling news: More than 7 million Americans are at least three months behind on their car payments. To put it in perspective, that’s 1 million more than at the end of 2010, after the recession.
What does this mean? It means, in many cases, Americans are buying more car than they can afford. The credit reporting agency Experian said the average monthly car loan payment in the U.S. was $530 for new vehicles in the third quarter of 2018. That is just over 10% of the median household income. It’s so troubling, U.S. PIRG issued a warning that the continuing rise in auto debt is putting many consumers in a financially vulnerable position that could get even worse during an economic downturn.
What’s behind this increase? Americans increasingly prefer larger, more expensive vehicles like trucks and SUVs. Auto research firm Edmunds reports the average price of a new vehicle is now about $37,000, compared with $27,000 five years ago. Interest rates are also going up. The average rate on an auto loan is 6.2%. One year ago, it was 5%.
So, that brings us to the question: how much should you spend on a car? Interest.com recommends a 20/4/10 rule. Make a down payment of at least 20%. Finance a car for no more than four years. And don’t let your total monthly vehicle expense—including principal, interest and insurance—exceed 10% of your gross income. Some experts now argue that rule is outdated, as many of today’s auto loans run from about six to seven years. Still, it can be a good rule of thumb.
Another guideline would have you spending no more than 20% of your take-home pay on a car. Again, including things like principal, interest, insurance and maintenance.
How do you know what’s best?
Everyone’s financial situation is different, and the answer to the car question can change depending on what stage of life you are in. Recent college graduates who just landed that first big job may want to purchase a nice, new car as a reward for their hard work. However, that person may also have student loan payments beginning in six months. The young adult may find themselves deeply in debt within their first year of entering the “real world!”
Young families may need a safe and reliable vehicle with enough room for car seats. These families may also have a hefty child care expense every month, plus all the other bills that come with running a household. The purchase of a new car may come at the expense of starting a college fund.
The underlying connection between these two scenarios: It’s important to take time to carefully consider how much you can really spend on a vehicle. Determine the impact on your monthly budget and also your overall net worth. If you are taking out a loan, how much are you adding to your existing debt load?
Buying a new car can be a thrilling and emotional experience. The shiny exterior, new car smell and technology can be so enticing, but buying a new car should not be an impulse decision. Have a number in mind before you go to the lot, and stick to it!