In the Market for a New Car? Here’s How to Figure Out What You Can Actually Afford

graphic of woman's hands holding a car and a bag of money
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Try this simple formula to make sure your new set of wheels won’t set you back financially.

For most people, the best part about shopping for a new ride is imagining themselves driving around in it. While a little fantasizing is fun and harmless, the damage you could do to your wallet if you buy more car than you can afford isn't. Instead of falling in love with a car first, then scrambling to figure out how to pay for it, doing the opposite is the smart way to go: Determine how much of your income you can devote to auto expenses before you even start your search.

The 20/4/10 Formula

While no financial formula is foolproof, this is a good one to keep in mind if you're looking to finance any car, new or used. The gist is simple: Aim to put down 20 percent of the sale price; stick to a four-year loan term; and try to keep your monthly payments, including insurance, at 10 percent or less of your gross income. (Some experts say that last number can go up to 15 percent.) Consider following this guideline to comfortably stay within your overall budget, so you won't be left struggling to make payments if your lifestyle changes—say, you have a new baby, or you or your partner loses a job.

The Down Payment

First things first: Figure out how much of a down payment you can make. If you have a car to trade in, use a vehicle valuation guide to estimate its worth. Add to that whatever amount you're able to pony up in cash. And for the sake of covering all your bases, scout around for cash rebates on the cars you've got your eye on; in many cases, rebates can be applied to the down payment. Calculate the total from all three sources, and let that number be your guide. For example, let's say $5,000 is the absolute maximum you can offer at the dealership. For that amount to equal a 20 percent down payment, the car you buy should cost $25,000 or less.


The Loan Length

In general, the shorter your loan term, the less you'll end up paying in the long run. It's true that your monthly payments will be larger, but the savings in interest you'll accrue with a four-year loan should make you think twice before signing a five-, six- or even seven-year loan. Plus, because cars are notorious for the lightning-quick speed at which they depreciate, a super-long financing deal usually means a longer stretch when you owe more on the vehicle than what it's worth (in lender lingo, this is known as being upside-down). Another way to think of it? If you can't pay off the loan in four years, it's probably outside your reach.

The Monthly Costs

Bust out the calculator—it's time to do a little math. Total up your monthly gross income and multiply it by 10 percent. Then, look up the average cost of insurance premiums in your area and subtract that (in 2017, the national average per year was $1,318, or about $110 a month). The number you're left with is the maximum you should put toward a loan. To put it into perspective, if you pull in $4,500 a month before taxes and pay the average insurance rate, you're looking at a max $340 car payment.

Of course, everyone's cash situation is different (they don't call it “personal" finance for nothing). But the bottom line is the same no matter your lot in life: When buying a car, begin by understanding what you can afford before you start looking. After all, the car that allows room in your budget to actually go places is the one you'll enjoy driving the most.