How Much You Should Pay for a New Car?

June 18, 2020

Like many other financial steps that you have to take in life, deciding to buy a car demands lots of reasoning and calculation. Since it can run into tens of thousands of dollars, it can affect your finances in various ways. While owning a car can help you move around with more freedom, it comes with certain financial implications that must be duly considered before parting ways with your hard-earned money.

Therefore, before you start searching for a car to buy, you should decide how much you are supposed to pay for a new car. This helps you make an informed decision and avoids certain pitfalls.

Using the 20/4/10 ratio

As long as paying for a new car is concerned, the 20/4/10 ratio is a smart financing option that you should consider.

20 – Pay at least 20% of the car cost

4 – Financing should not be over 4 years

10 – Repayment plan should not take more than 10% of your monthly income

How does this ratio work?

  • Pay a minimum of 20% as a down payment

Once you have bought a new car, it loses 9% of its value immediately. In addition, it must have lost around 19% of the value by the end of the first year. Therefore, if you pay less than 20% as a down payment, it means that your debt on the car is more than the value of the car within a year of buying it.

The implication of putting down less than 20% is felt if you have to sell it to settle the auto debt. In such a case, you need to add more money to the value of the car to pay the auto loan. Getting involved in an accident within the same period will even make the situation worse for you.

  • Auto loan term should not be more than 4 years

You must realize that if you choose a longer loan term, you will have to pay a higher interest. Also, a longer loan term will increase the chances of meeting the insurance requirements of your lender; hence, you may have to pay higher rates. So, you must choose a short loan term.

If you can pay off the loan in 3 years or less, you will enjoy massive benefits and own the car outright when the value of your car is still relatively okay. Whatever the case may be, make sure the loan term doesn’t exceed 4 years.

  • The total payment of the car must not be more than 10% of your gross monthly income

A total car payment refers to the amount you need to pay monthly for the principal, interest, and insurance. You must note that car loan is not the only thing that you need to spend on; you still have to deal with rent or home down payment, emergency fund, utility bills, vacation, and other things. Besides, you may experience adverse financial changes that will reduce your monthly income.

Therefore, by ensuring that your total car payment is less than 10% of your pre-tax monthly income, you will be able to settle it without putting other aspects of your life on hold.

In addition to the 20/4/10 rule above, you can also think about adopting the 36% rule. This rule says that you must not spend more than 36% of your total monthly income on loan payments – car loan, student loan, personal loan, mortgage, etc. For instance, someone who makes $5,000 monthly must not spend more than $1,800 on all loan payments per month. This 36% rule allows you to manage your finances effectively during the period of repaying your car loan.

Based on these rules, you should be able to determine how much you can pay for a new car. If it seems that you cannot afford it, you should reconsider your choice to avoid any action that you may regret later.

Financing your car

Another essential thing that you must consider is how to get the loan that you want to use to finance the car. Make sure that you get a loan from a trusted lender that offers you the best deal. The interest and other fees must not lead you into a financial problem. If you are buying a car with poor credit, you should be more careful to avoid falling into the hands of predatory lenders that will take advantage of your situation.

Overall, buying a car is an impactful decision that must be taken after due consideration. So, follow the rules mentioned above to understand how much you should pay for a new car.

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