Personal Finance

How Nice of a Car Can You Afford?

Cars, like homes, are one of those big-ticket items that many of us don’t completely pay down the day we sign our paperwork. Sticker prices are as high as ever, as the average new car costs $33,453, according to Kelley Blue Book. And as loan terms lengthen – more than half of buyers have five plus years to pay it off, says Experian -- the average monthly payment for a new car is $488. For a used car, it’s $355, although consider that the average interest rate for a new car purchase (4.71%) pales in comparison to that of a used car (9.17%).

The question remains: Whether you opt to go new or used, what’s the biggest car payment you can reasonably afford?

Do the Math: The Answer Is in the Numbers

Multiply your household income by 0.36, and subtract the existing, recurring payments you're making (i.e. mortgage, credit cards, et cetera). The remainder is about what you can expect to see from a lender.

Lenders prefer to see debt-to-income ratio below 36%. Let’s use the average American household income($63,784) and follow the math. A lender would be OK with this buyer spending $22,962 on required payments, such as student loans, credit card minimum payments and car payments.

What about a longer loan? If you are tempted to go this route, realize that it will adversely impact the amount of interest you will owe. Let’s take some new-car averages as an example: the average loan amount ($28,711); the average interest rate (4.71%); and the average term (67 months). Those three numbers would result in $4,000 worth of interest over the loan’s life. Now change the term length to 48 months. What happens? The interest total decreases to $2,846, representing a savings of about $1,150. It’s a money-saving adjustment if the buyer can stomach higher monthly dues: $488 per month over 67 months or $657 per month over 48.

Let's go through the same exercise for a used car. To the national averages: transaction amount of $18,213; interest rate of 9.17%; term length of 62 months. Under these circumstances, the payment would be $370, with $4,722 in interest. Now shrink the term length down to 48 months, and the monthly payment would rise to $455, with a decreased interest total of $3,612.

Avoid Interest: Tips before Agreeing to Terms

It’s typically best to avoid paying interest, unless of course your money is sure to grow over time. (If that’s the case, writing an investment column may be in your future.) For the rest of us, avoid interest by making additional loan payments or even pay it off early. Ask about this and other options before agreeing to a dealership’s financing terms. Even if you plan to pay it all off early, choose “simple interest,” an as-you-go-charge, not “pre-computed interest,” which requires you to pay the entirety of the interest for the full term of the loan. Be on the lookout for contracts with penalties for early payments.

Regardless of your strategy, ensure that you make your payments timely to not incur late fees or wreck your credit score. The latter will come in handy the next time you make another big purchase. But so will a short-term savings account, which you should seed with the amount of your loan payments long after your loan has been paid off.

After all, cars on the road today are an average of 11.4 years old, according to the Department of Transportation. Twenty years ago, the average age of vehicles was just 8.4 years. So be sure about your loan terms, yes, but also be sure you're picking the right ride; it's going to be yours for a long time.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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