While most of us would like to think that we deserve a brand new set of wheels, the truth is that most people underestimate the expense of owning a vehicle. Before you lock yourself into a payment you can’t afford or purchase a lemon, do your homework first: is this a smart buy?
The first step to any large purchase is to have a frank discussion with yourself about what you can truly afford. It’s tempting to start with the car you want and work your way backwards from there, but this method often ends in bitter disappointment; setting realistic expectations from the beginning makes for an overall more satisfying experience. Rather than dreaming of that brand new car you aren’t ready for yet, be honest with yourself and realize that settling for something more reasonable is going to help you achieve your other financial goals in the long run.
To come up with the number you can afford, take a close look at what you currently have leftover at the end of each month; it’s easy to imagine cutting back on some things to make that car payment, but trust me when I say a few years in you’ll be wishing you opted for something more manageable. A great way to test out what you’ll actually be able to afford is to put that money aside in a savings account while you’re car shopping; you’ll get used to missing that money, and can save up for a down payment in the meantime.
Once you’ve come up with that monthly number, consider how long you want to be paying that for. If this is a new car, many dealerships offer loans extending up to 7 years, but will you still want to be paying off this vehicle 7 years from now? If your plan is to buy a house within 5 years, consider finishing your car payment before that time; you’ll need the additional money, and any existing loans are taking into consideration when approving your loan, so getting a more expensive car now means you can buy less house later. Weighing the cost/benefit of your vehicle purchase is crucial; what are you giving up so you can drive this car, not only now, but several years from now?
If you’re looking at used cars and you know what you can afford in a monthly payment, multiply that by 24 or 36 months and that’s what you can buy if you’re taking out an auto loan – if you think you can handle $120/month, with a 36 month loan, that comes out to $4,320 to spend on a used vehicle. BUT WAIT – what about interest? Take a close look at your credit score and shop around for rates – at 5% interest, now you can only afford about $4000 worth of car, so be cognizant of what interest does to the total amount you can afford.
In the above example, your payments come out to exactly $119.88 – how do I know that? Excel has templates and simple formulas that you can use to figure out what a payment would be based on different factors; plugging in different principal loan values, interest rates, and length of time can help you come up with a plan that works for you.
Doing this exercise lets you see exactly what your monthly payments would be so there shouldn’t be any surprises when it comes time to purchase; these are the same formulas the dealership or bank uses to come up with your payment, so get familiar with the math. Knowing what goes into a loan payment takes some of the intimidation out of the process, and prepares you to go in with numbers in mind before signing anything.
The above scenario is a simple one, but gives you an idea of how the numbers change by adjusting the various inputs. Try looking at different interest rates, different principal loan amounts, and see how the numbers change based on each factor. You might see that you’re ok going up to 6% interest at 36 months, or that you actually need to pay your car off over a longer period of time. Do the math now so that nothing will surprise you; I’m a firm believer in arming yourself with information, and this is the perfect time to show a salesperson that you’ve done your homework.
Now that you know how to manipulate the figures, let’s go back to the new car scenario. Let me start with a few basics: if you can’t put any money down, you have no business buying a new car. That’s not a fun fact, but it’s reality; if you haven’t saved up some money to bring that principal loan value down a little bit, it’s unrealistic that you’ll somehow magically come up with those high payments each month without suffering in other areas. The general rule of thumb is at least 10% down, but err on the side of caution with at least 15-20%; it sounds like a lot, but it could be the difference between a payment you can afford and a vehicle that burdens you for the better part of a decade.
The other thing to consider with a new car is that you may want to purchase a warranty or additional add-ons for the vehicle; factor this in when looking at the purchase price – a car advertised at $20k can easily sell for $25-30k after add-ons and extended warranties. Be sure you know the exact cost of the car you want before buying so that you don’t run into any surprises – keep in mind that their job is to sell you something, so as nice as that guy at the dealership is he’s making commission off your sale, and he’s incentivized to upsell you any way he can.
We’ve covered monthly payments, down payments and what you can actually afford in the purchase price of your car, but most people forget to factor in maintenance and insurance. Call your insurance company ahead of time and get a quote on the vehicle you’re looking at; keep in mind that brand new vehicles can come with a hefty price tag when it comes to insurance. Research online forums and find out what problems other people have had with your vehicle; will you need to replace the transmission after 100,000 miles? Having this information ahead of time and budgeting for it now is going to save you in the long run, so do your homework and go in prepared.
Another cost to consider is gas mileage; while we can’t always anticipate the price of gas, you will feel the difference if you go from a small commuter car to a big gas-guzzler, so factor this into your monthly payment. With more fuel-efficient vehicles coming out this can sometimes work in your favor, but be sure to weigh the added cost; is your new hybrid going to save you the extra money it costs upfront? How long until you break even? Have you researched the cost of adding a charging station to your home for your new electric car? Knowing all the added costs upfront might change your mind about what you can afford, rather than finding out the hard way.
The last thing you want to keep in mind is the resale value of your vehicle; are you buying a color that not many people would choose? Will you be able to get a decent amount of money when you’re ready to sell in 5-10 years? This prediction can be tricky but having an idea in mind of what you could sell your car for will factor into it’s overall value; is this a family vehicle you can count on for 15 years, or is this a trendy car that no one will want once the new version comes out?
If you’ve done your homework and feel well-researched, the car-buying experience can be an enjoyable one. While surprise parties and surprise flowers are always nice, surprise payments are not something you ever want to deal with; whether you’re buying new or used, going in knowing what you can spend shows that you’re a smart and knowledgeable buyer, and sets the groundwork for a smooth transaction.