How much car can you afford? The 20% Rule
February 20, 2012
Are you ready to take control of your money? If so, then follow the 20% rule to determine how much car you can afford.
If you haven't seen my previous rant on why new car sucks, you won't understand the reason I'm so against them. In summary, I took out a huge loan on a new car that brought me to my breaking point. At the time, I made $45,000 a year and bought a car with a $28,000 loan!!
Ok, so I don't actually mean all new cars sucks; only new cars you can't afford. If you can afford a brand new Benz, then good for you. However, you need to figure out how much car you can afford.
Buy a new car only if you can afford it with cash! That's right. Cold, hard, cash. We've been duped into spending our hard earned money on expensive cars for way too long. Your car is not a status symbol that lets the world know you're successful. In fact, if you're trying to use your car as a status symbol, you'll probably never be rich!
According to Dr. Thomas Stanley, "86% of those who drive prestige makes of motor vehicles are not millionaires [having an investment portfolio of $1M or more-see Stop Acting Rich]." Yes, I'm looking at you Dallas… home of the $30,000 (salary) millionaire driving around in your leased BMW! I lived there for five years, so I'm allowed to say that.
How much do millionaires actually spend on their cars? Dr. Stanley's research shows "the median price paid for the most recent motor vehicle purchased by a millionaire was $31,367 [for decamillionaires-$41,997]." That's right, millionaires only spend on average of $31k on a new car!
So here's how to figure out how much car you can afford: follow the 20% rule.
The math is simple. How much money do you make in a year? Take 20% of your gross annual income (before taxes, social security, etc) and that's what you can spend. Preferably, you should purchase with cash as well.
If you are in a relationship and you combine salaries, you should add up both incomes and divide by two. If you want, you can split the amount up differently (60/40, 70/30, etc), but make sure you don't surpass the 20%.
Quick example: one person makes $40,000 and the other makes $30,000. The combined salary of $70k means $14k worth of cars can be purchased. If you need to buy two cars in one year, you can split up the $14k however you'd like - keeping in mind the majority will probably go to the wife!
Cheat sheet on how much car you can afford:
$20,000 salary = $4,000 car
$40,000 salary = $8,000 car
$80,000 salary = $16,000 car
$140,000 salary = $28,000 car
$200,000 salary = $40,000 car
That means when I purchased my $28,000 car, I should have spent $9,000 instead (based on my $45,000 salary X 20%)! I was $19,000 over what I should have spent, and that explains why I was also broke! Obviously, I shouldn't have been anywhere near the new car lot when I was shopping.
Next time you get car fever, remember to follow the 20% rule to determine how much car you can afford!
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Comments
Other car purchase considerations
I would recommend that people also research the cost of fuel (MPG) and maintenance of a vehicle they want to purchase. So when comparing purchase costs, also look at costs of maintenance and fuel over the next 5 to 10 years too. It could be that costs of a NEW car purchase beat a used vehicle. if your research shows that a new fuel-efficient vehicle at a low interest rate beats purchase of a used car, then by placing a large cash down payment (75%%???) and financing a small amount at low interest (under 5%) on the new car, you can come out ahead.
Consider the whole equation. It's not just 20% of today's income, but 20% of of today's income PLUS the cost of maintenance and fuel economy over the next 5 years.
Good To Know
One thing is for sure, no one should never buy something that will give the appearance that we are in a better place financially then we are. I did what you did at one point tin my life and bought a Benz. That is was when other people started asking for more from me then I had to give, as if I were wealthy and I owed it to them to help them out.
The Benz is long since gone and I now drive a very modest car. One that does what I need it to do and I don't have a car payment. All that is a good thing.
:-), Susan
Interesting
I think I spent a about 45% of my annual salary when I bought my car. Yikes! I never thought about it that way. I make more now, but I would have to double my current salary for the price of my car to be only 20%
But I took a different approach to deciding how much I could afford. Before I even looked at cars, I looked at my budget. I figured out how big a car payment I could handle. Then I assumed a high interest rate, calculated the principle amount for those parameters and added in my down payment. I reduced the total by about 10% to give me some wiggle room, and the result was how much car I could affort. After that I made a list of what I wanted and found a car in my budget. Admittedly, it was pretty close to the top end of my budget, but it was exactly the car I wanted and I intend to keep it for another 5-10 years.
And, I just paid it off last month.
In retrospect, I don't regret spending so much on my car because, even then, I knew how to do the math and my allowable payment was based on the lifestyle I had back then. For someone that hates math, or doesn't have a strong grip on where their money goes, the 20% rule could save their lives.
If I had heard this rule 4 years ago, I might have done something different.
 Julie - I still beat you
Julie - I still beat you with my ~62% car purchase to income ratio! You spent a lot more time thinking through the purchase than I did so you were in better shape. The best part is that you plan to keep it for a long time and live without car payments.
I like the 20% rule because it forces people to think through the total purchase amount - not just the monthly payments. We're so accustomed to buying really expensive cars and thinking its normal. Thanks for telling your story!
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