Buying a car can be both a stressful and an exhilarating experience. The biggest mistake most people make is not deciding on several key factors up front. In order to get the most suitable car for your needs, you'll need to establish a solid plan before you go shopping for a car. Alan, a marketing manager, just got promoted and is asking himself, "Can I afford a car?" After making a few decisions and running a few numbers, he's off to the races.
Budget
The first step in determining whether you can afford a car is to decide on your budget. This number should be the highest price you are willing to pay including taxes, insurance and fees. Alan is currently making an income of $85,000. There is a possibility he will get a raise soon, but with the current state of the economy, his job isn’t set in stone, either.Alan contemplated three things before going out to shop for a car: Did he want new or used? Should he lease? Or should he buy outright? These aren't easy questions to answer, as they often bring even more uncertainties to light.
There are several benefits to buying a new car: When you buy a new car, you don’t have to worry about previous maintenance records and all the mess that could go along with a sordid vehicular history. However, with a new car, you'll be paying a premium to not have to deal with those worries.
Leasing often involves higher insurance costs and a high level of scrutiny when the vehicle is returned. Leasing works well if you drive only 10,000 to 20,000 miles per year because a cost is added for extra miles driven. Some financial experts argue that it is better to buy appreciating assets and lease or rent depreciating assets. Alan liked the idea of having a new car without maintenance worries, but he drives too many miles to lease a new car.
Debt ratio
Less than one
The first calculation to determine whether you can afford a car is that of your debt ratio, which shows the percentage of debt to assets you own. Take your total debt and divide that number by your assets. The lower the number, the better off you are, until you go into negative numbers. Therefore, your debt ratio should be less than one.If you are buying a new car, it is important that you pay off all short-term credit card debt. If your debt ratio is greater than one, meaning that you have more debt than assets in the bank, you should buy a used car if you must have a car at all.
When buying a used car, always get it checked out by a qualified, certified and trustworthy mechanic. Also, research various dealerships' pre-owned plans with vehicle inspection programs. Alan looked at all the dealership's certified pre-owned cars before he test drove a few new cars to see the differences.
Car price to equity ratio
No more than one
In answering the question, "Can I afford a car?" the next calculation to make is the car price to equity ratio. Take the final price of the car and divide it by the total amount of assets you have in the bank. The lower the number, the better off you will be financially. If the number is too high, you are buying too much car for the amount of money in your bank account.For example, Alan has $50,000 in the bank and the car he likes costs $15,000, giving him a ratio of .30. Now, if he had $75,000 in the bank and the cost of his car was $15,000, then he would have a ratio of .20, which is lower and better. The second example shows a more sound financial decision on Alan’s part.
Interest and principal payment amount
No more than 20% of monthly net income
The last calculation to make is that of the interest and principal payment amount. Every loan compounds interest differently. Some loans compound daily, some monthly and others annually. However, a basic interest computation can be done using the percentage of your interest rate.Let’s say Alan got an interest rate of 5% and the price of his car was $25,000. For this calculation, you would multiply .05 and 25,000 to get $1,250, which is roughly the amount he would pay in interest annually. The key is to make sure you can afford your monthly payments. This means that the combined principal payment and interest payment should be no more than 20% of your monthly net income.
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