4Q2019 | 18-29 yrs
Buying a Car: What can you afford?
It’s Holiday season and you know what that means.. we are about to see all sorts of deals on cars. But how do you know if the deal is right for you. Sure, cars can be a lot of fun, but for most people, the experience of purchasing a car is not something they look forward to, and spending too much on a car can leave you with a holiday hangover.
Buying a car is an important financial decision. It could be argued that buying a car is the second-most expensive purchase you will make. Depending on whether you buy outright with cash, lease or borrow, the decision will leave a financial impact with you for several years.
Before you begin shopping for a car, you might want to think about how much it will cost you. A good rule of thumb is that for every $1,000 you borrow, you will have a monthly payment of $20 per month on a 5-year loan. So in other words, think about how much per month you can afford on a car payment. Take that amount and divide it by $20, then multiply by $1,000. That is the most you should borrow for a car.
Let’s look at an example. Suppose you can afford a $200 monthly payment:
$200 monthly payment / $20 = 10
10 x $1,000 = $10,000 car loan
Don’t get caught up in the hype: Experian recently reported that the average amount borrowed to buy a used car was $20,137. The average borrowed for a new car was $32,187. That means those payments would be approximately $400 to $643 per month. These amounts are more than the average American salary can afford.
On top of that, there are other expenses related to cars that most people overlook when they are in the buying mood. Those expenses include taxes, increased insurance, and most importantly, the opportunity to use the car payment money for long-term savings.
Consider the examples above. Let’s compare someone with a $200 payment to someone with a $400 payment. The $200 difference could be invested in a Roth 401(k). If the investment earns 7% per year, the extra $200 per month would grow to $14,320 at the end of the 5-year loan. Depending on your length until retirement, that new $14,320 would be worth:
$28,179 after 10 years
$39,509 after 15 years
$55,413 after 20 years
$77,720 after 25 years
So, when you stop to think about it, those amounts can have a real impact on your future self. If you used the Roth 401(k), that money would be tax-free. Whereas, the dream car you had hoped for will have only gone down in value.
When writing this article, I was doing some research and came across a neat article from Sam Dogen at Financial Samurai. He suggests only spending a tenth of your income on a car. For example, if your income is $42,000, then you should consider only paying $4,200 on the purchase price of your car. [i]
The following chart is from his article.
My approach would be to consider meeting with one of our firm’s financial advisors to determine what your budget should be. Your financial advisor can tell you if you are on-track towards other goals such as retirement and saving for college. Once you have geared your budget towards these goals, you can use the formula I described above to determine your purchase price, and whether or not you want to borrow any money.
For more information, please contact your QPA Financial Advisor.
Advisory services offered through Prime Capital Investment Advisors, LLC. (“PCIA”), a Registered Investment Adviser. PCIA: 6201 College Blvd., 7th Floor, Overland Park, KS 66211. PCIA doing business as Qualified Plan Advisors (“QPA”).
This commentary is provided for information purposes only and does not pertain to any security product or service and is not an offer or solicitation of an offer to buy or sell any product or service.