Calculate How Much Car You Can Afford
It doesn't make sense to be looking at a Mercedes when all you can afford is an entry-level Honda.
There are 3 factors that make up your total car budget:
- Down Payment - cash from your current savings
- Trade-In Value - what your current car is worth (minus outstanding loans)
- Car Loan Amount - amount you can finance, called Loan Cash
You can use any combination of these 3 factors to pay for a car. Some people are lucky enough to pay all cash and don't need a car loan, but if you're like most, you'll need to finance at least some portion of the payment.
Step 1: How Much do You Have for a Down Payment?
The first step is to figure out how much available cash you have to put towards the car.
If you have a large amount of savings, you can pay 100% cash for your car, saving you interest payments.
Keep in mind you don't want to tie up all of your available cash as a down payment. Experts recommend you have enough cash for at least 2 months worth of living expenses in case of an emergency.
A good rule of thumb for a down payment is at least 20% of the purchase price of the car.
Step 2: Figure out Your Trade-In Equity
Assuming you currently have a car that you'll be selling or trading-in, as long as the car is worth more than what you owe on it, you have trade-in equity.
Let's say your car is worth $10,000 and you still owe $5,000. Your trade-in equity is $5,000 - this is the amount that can go towards the purchase of a new car.
For this exercise, you can just come up with a ball-park figure. But when you have more time, you should follow our Car Selling Guide to determine the true value of your trade-in.
Step 3: Figure out The Monthly Payment You Can Afford
Most car buyers can't afford to pay cash. Assuming you're in this boat, you're going to need a loan to help pay for the car.
First, you need to determine what kind of monthly payment you're comfortable with. Most experts recommend no more than 15% of your take home pay (that's after taxes). If your take home pay is $5,000 per month, then your maximum monthly payment should be $750.
The figure you're comfortable with may be higher or lower depending on your current financial circumstances, but it's important to be honest with yourself and err on the side of caution. Don't forget car insurance will add 15-20% on top of this payment.
Step 4: How Many Months Do You Want to Make Payments
The last step is to decide how long you want to be making car payments. I recommend car loans that are 48 months or less. If you really want to push it, a 60 month loan is the maximum you should ever get.
The longer your car loan term, the more you'll pay in interest. (See: Why It's Better to Get Shorter Term Loans)
Car Affordability Calculator
Here is a simple calculator that will show you the total amount you can finance based on the monthly payment you can afford. You'll have to enter an interest rate. To get an idea of what your rate will be, see: Which Rates You May Qualify For Based on Credit Score.
Using the examples in the calculator, if you can comfortably afford a monthly payment of $425 at an interest rate of 8.99%, then a 48 month loan will get you $17,082 towards the purchase of a new car.
You can then add your down payment and trade-in equity to this figure to get the total you can afford. Let's assume you have $2,500 as a down payment and your trade-in equity is worth $2,500.
$17,082 + $2,500 + $2,500 = $22,082
$22,082 would be the total amount you can afford for a new car, including taxes and all fees.
Each week, I'll keep you up-to-date on the latest car deals and news that might affect your purchase. This includes...
- Best Rebates, Incentives, and Lease Deals
- Latest Car Buying Scams and Tricks
- The Best & Worst Time to Buy a Car
- Which Cars You Should Avoid
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