When you’re buying a car, the first thing you need to do is create a budget. Yes, budgets are dull, but they are important. They serve as a guide for demonstrating how much you can afford to buy a car. It will also help you to decide whether you want to buy a new or used vehicle and how you’ll pay for it. In other words, a budget is the starting point for helping you to make a difficult decision.
When looking at auto loans in Canada, you should keep in mind the 20/4/10 rule while creating your budget. This rule advises that to afford a car properly, you should give a downpayment of at least 20% of the car’s purchase price, limit your car loan to four years or less, and your monthly payments should be less than 10-15% of your take-home pay. Using this rule, you can determine how much you can afford to pay for a car. Let’s explore this advice a little bit further.
A 20% Downpayment
If you offer anything less than 20% of the car’s purchase price, you could end up paying more than what the car is worth by the end of the year. This is known as negative equity. This is because a vehicle tends to depreciate in value by 9% when you drive it off the lot. As a result, by the end of the year, the car will have lost about 19% of its value. Therefore, if you purchase a vehicle for $20,000 with 0% down, your vehicle will be worth $16,200 by the end of the year as a result of depreciation. If we assume that you’re paying 4% APR interest on a five-year loan, this means you’re paying about $370 per month, and you have a remaining amount owing of roughly $15,560. However, this amount doesn’t include applicable taxes, fees, and finance charges on the loan itself.
If, however, you were to put 20% down, your car payments would be $295 per month, and you would only owe $12,460 (not including additional charges). You would then owe less, pay less per month, and be almost halfway to paying off the car altogether.
A Car Loan Term of Four Years or Less
The longer your car loan term, the more interest you’ll pay. In general, financial experts recommend a loan term of 48 months. However, if you can afford it, 36 months is best. Although if 48 months is too expensive, you can stretch to 60 months. However, it would be best if you didn’t go further than that. If you can’t make payments work at a 60-month term, you should look at a less expensive car.
A Monthly Payment that is Less than 10-15% of Your Take-home Pay
Let’s say you have a salary of $50,000. This means you take home roughly $38,869 (income tax varies by province). If we calculate 15% of this take-home pay, you would have $5830.35 to spend on a car per year. This translates to car payments of $485.86 per month.
This means that if you can put down a downpayment of $6000, you can afford to buy a $25,000 car, at 4% interest, over four years, with monthly payments of $429.05.
Other Factors to Consider
When considering how much you can afford to pay for a car, you can’t forget to take car insurance, gas costs, and maintenance costs into account. You will need to shop around for the best car insurance plan and factor this cost into your budget. You will also need to factor in how much gas you will spend, and you should put aside some money for car maintenance as well.
For example, if you budget $100 a month for maintenance, $200 for gas, $200 for insurance, and $50 for things like parking fees, you’ll end up needing around $1000 a month for your vehicle. This means, if you take home $38,869 a year, you’ll have about $2200 left in your monthly budget for things like rent, utilities, groceries, etc.
Financial experts advise using the 20/4/10 rule to determine how much you can spend on a car. In other words, you’ll need to be able to afford to put down a 20% downpayment, over a four-year term or less, at a monthly payment rate that’s 10-15% of your take-home pay. Consequently, you’ll need a budget to figure out how much of a car you can afford to follow this rule. In this budget, you’ll also need to consider other costs associated with owning a vehicle, such as gas and maintenance costs. Once you’ve created this budget, you’ll know how much you can afford to pay for a car.