For most american households, transportation costs eat up more of the annual budget than anything other than the house itself. Nearly all of that transportation money is spent on cars and car-related expenses. Data collected by the Bureau of Labor Statistics shows that transportation is the second-biggest expense for most households across the U.S. Hence, we need to be careful with vehicle expenses. Here are some general rules of thumb:
1) 20/4/10 rule: This simply states when purchasing a car put at least 20% down, finance for no more than 4 years and keep the monthly payments to no more than 10% of your gross income. If you need to finance for more than 4 years it is a sign that you cannot afford the vehicle.
2) Vehicle expenses including vehicle payments, insurance, and maintenance should not exceed 20% of your monthly take home pay.
3) Total value of your vehicles should be less than half your annual income.
Why do we want to be smart with vehicle costs? Seems like a no brainer, but for those of you who need a basic rule of building wealth, remember rich people buy assets that appreciate and most vehicles depreciate in value. After 5 years of ownership most new cars are worth 37% of what you paid for it. If you weren't following these guidelines and purchased a new car for $40,000 while making $50,000 per year you'd lose $25,200 in 5 years or $5,040 per year on average. If you were making $50,000 per year that is a negative savings rate( -10% per year $5,040/$50,000=0.1008x100=10.08% per year). Your car is literally killing any chance you have of getting ahead in life.
Let's run this example through our guidelines:
Guideline 1: To purchase a $40,000 vehicle, you would need 20% down ($40,000x0.20=$8,000), per month payment for 48 months equals $667 to $730 (0% loan to 4.5% loan), 10% of gross income is $5,000 for the year or $417 per month. Your monthly payment $667 is greater than $417 per month. Result: don't buy this vehicle.
Guideline 2: If you make $50,000 per year your take home pay is roughly $38,700. This is $3,225 per month. Your total car expenses should not exceed $645 per month ($3,225x0.20%=$645) Monthly payment on a four year loan with 0% interest equals $667. Not factoring in your other vehicle expenses like registration fees, insurance, etc. $667 is greater than $645 per month. Result: don't buy this vehicle.
Guideline 3: This is the simplest calculation, half of your income is $25,000 and $40,000 is greater than half your income. Result: don't buy this vehicle.
"Car payments and big car purchases will make you broke and keep you broke," Dave Ramsey. The alternative to an unaffordable car, if you make $50,000 per year in income, you can most likely afford a car worth $15,000-$20,000. Click for useful auto loan calculators.