How Much Car Can I Afford?

Cars are necessities for a majority of Americans. The average U.S. household owns two of them. These vehicles transport us to work, to school, to buy groceries, to visit the doctor and to spend time with our friends and family. Sales of cars and light trucks have been climbing year-over-year since 2010, recently reaching pre-recession levels. As many Americans head out to car dealerships to pick out a new set of wheels, perhaps you’re considering a replacement ride for yourself. If so, you might be wondering how much car you can afford.

Average Cost of a Car

The average sale price of a new car is $33,453, according to analysts at Kelley Blue Book; which is more than half of the average U.S. household’s annual budget of $63,784. The average price of a used car is $18,100, according to Edmunds.com's Used Vehicle Market Report.

These prices might appear startlingly high, but they aren’t telling the whole story. Technological advances have led to cars that last longer than ever before. Many continue to run smoothly for more than 200,000 miles.

The average car on the road today is 11.4 years old, according to the U.S Department of Transportation. Back in 1995, the average age of cars and trucks on the road was 8.4 years. That’s an increase of more than a third. Also, when measuring inflation, the U.S. Bureau of Labor Statistics adjusts car prices for changes in quality. According to this metric, vehicle prices have been fairly flat since 1995.

Even though sticker prices are substantial, a combination of forces are helping people fit the purchase of new—and used—cars into their monthly budgets. The Federal Reserve has kept interest rates generally low; while lenders are offering financing over longer stretches of time, which helps bring down buyers’ monthly payments. More than half of new car buyers are getting loans for five years or longer, based on recent figures from Experian.

The average monthly payment for a new car is $488. For a used car, it’s $355. A person hoping to spend less on a car might choose a used one, however he might end up paying almost twice as much in interest over the course of the loan. This is because lenders bake in a few additional factors, such as the uncertainty about a used car’s reliability; and generally lower credit scores of used car buyers. The average interest rate for a new car purchase is 4.71%; for a used car, it is 9.17%.

What Car Payment Can You Afford?

Here’s one way to figure out the car payment you can afford: Take your household income and multiply it by 0.36, and subtract the existing payments you're making on your mortgage or credit cards, etc. The remaining amount is considered most lenders will be comfortable with extending to you.

Lenders typically consider your debt-to-income ratio, and prefer to see that number at or below 36% (though some lenders will allow it to creep higher). That means, if you earn the average U.S. household income before taxes of $63,784, a lender wouldn’t mind if you spend $22,962 of it (that’s $1,914 per month) on required expenses including your mortgage or rent payment, student loan payments, credit card minimum payments, child support or alimony or legal judgments, and your car payments.

About 28% of U.S. households are currently paying off a vehicle. Across the millions of old and new vehicles, the typical household reduces their loan principal by an average of $408 per month. They pay an average of $61 per month in interest on their auto loans.

Car ownership also leads to expenses for maintenance, gas and auto insurance. Despite all these costs, Americans are actually paying a much smaller percentage of their incomes on transportation compared to decades past. In 1984, we spent 19% of our incomes on transportation; in 2013 it was just 14%, according to the Labor Department’s Consumer Expenditure Survey.

Term vs. Interest Payments on Your Car Loan

If you are tempted to accept a longer loan for a car purchase, consider that it will increase the amount of interest you will ultimately pay. If you financed the average loan amount ($28,711) for a new car at the average interest rate (4.71%) over the average term (67 months), you would pay almost $4,000 in interest over the life of the loan. However, if you financed that same amount for 48 months, you would end up paying $2,846 in interest—a savings of about $1,150. That savings comes with the challenge of higher monthly payments. You would pay $488 per month in the 67-month scenario, but $657 per month in the 48-month scenario.

For the average used car transaction amount of $18,213 financed at 9.17% over the typical 62 months, the payment would be $370, and you’d end up paying $4,722 in interest. If you squeezed the loan down to 48 months, the monthly payment would be $455, and you’d pay just $3,612 in interest.

It’s always better to not be paying interest—unless you can assuredly make more by investing, but these days, that’s hard to predict, especially at the higher interest rates for used cars. However, it’s not realistic for most people to save up many thousands of dollars before they buy their first car, especially since the car can enable their money-making opportunities, like getting to school or to work.

Prepaying the Car Loan

One way to avoid paying so much interest is to make additional payments toward your loan along the way, or even pay it off early. If you think you might be able to do this, ask about the option before you agree to the financing terms. You should opt for “simple interest,” which charges you as you go, as opposed to “pre-computed interest,” which requires you to pay the full amount of interest for the original term of the loan, even if you pay it off early. In addition, some contracts charge prepayment penalties.

If you’d like to pay off some or all of your car loan early, contact the customer service department of your lender to find out what you need to do, and how it will benefit or harm you financially. And if you plan to stick to the original terms of the loan, make sure you make your payments on time to avoid late fees and potential harm to your credit score.

Once you pay off the loan, hang onto the car as long as possible, while continuing to put the monthly car payment amount into a short-term savings account. You can ultimately use that sum of money to buy your next car, avoiding interest payments entirely.

In the meantime, enjoy your ride!

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