Along my personal financial journey, I have had the privilege of coming across innumerable, valuable resources. Among them was the Money Guy show. This is a podcast and YouTube channel is produced by two licensed financial professionals. One of the many topics they cover is a formula for purchasing a new or used car. They suggest making a 20% down payment, having the car paid within 3 years’ time and not having a payment that exceeds 8% of your take-home pay.
Keeping a car purchase within these guidelines would be wise decision for 3 reasons:
1) Making a health down payment on a car provides immediate equity and reduces the amount that is financed and subject to interest. Unless you are financing a car through an institution like a credit union or bank with which you have an existing relationship, the interest on the loan will likely be high. By making a 20% (or larger) down payment, the amount of your payment being applied to the principal of the loan will be greater and the amount of interest paid over the life of the loan will be less.
2) The terms for car loans seems to just be getting longer and longer. According to Car and Driver, “in 2019, the average term length was 69 months for new cars and 65 months for used vehicles.” According
to Forbes, citing an IHS Markit study, “the average length of new-vehicle ownership in the U.S. stands at 79.3 months, or nearly seven years.” This means that, on average, Americans own new cars for only 10.3 months longer than they are financing them. According to Credit Karma, the average car payment is $644.
o $644 per month for 10 years is $77,280. However, if a person kept a car for 10 years after paying it off and invested the difference, they would have $108,040.
§ Investing $644 per month, compounding annually, assuming 7% return
3) A car payment is just one of many expenses that most of us will have each month. When making any large purchase, it is important to consider it in the context of your entire budget. It is also important to allow room for variation in budget items that are not static from one month to the next. For example, the payment on a car might stay consistent but there is no guarantee that gas and maintenance will stay consistent. A $600 car payment might fit into your budget when gas is $2/gallon but does it fit in
the budget if gas becomes $6/gallon? What if the car has particularly expenses replacement parts? Keeping the monthly payment to less than 8% of take home pay is just one way to help keep your budget balanced and prevent strain.
References:
https://moneyguy.com/2020/11/how-to-buy-a-new-or-used-car/
https://www.caranddriver.com/research/a31758321/average-car-loan-length/
https://www.creditkarma.com/auto/i/what-is-average-car-payment
https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator