How Much Car Debt is Too Much?

Buying a car is an exciting experience. However, taking on too much debt to finance your vehicle can quickly turn into a financial burden. So how much car debt is too much? Here are some tips to help you figure out an affordable car payment.

Assessing Your Overall Debt Load

Before deciding how much to spend on a car, take a close look at your overall debt situation. Here are some signs that your total debt level may be too high

• Your monthly debt payments exceed 36% of your gross income. This includes your mortgage or rent, credit cards, student loans, and other debts

• You’re living paycheck to paycheck with little or no savings.

• You’re unable to make contributions to retirement accounts.

• You don’t have at least a $500 emergency fund.

• You’re relying on credit cards for cash advances and everyday expenses.

If several of these warning signs apply to you, your priority should be reducing your existing debts before taking on a new car loan.

Weighing the 20/4/10 Rule

A common guideline for affordable car loans is the 20/4/10 rule:

• Down payment of at least 20%
• Loan term of 4 years or less
• Monthly payments of no more than 10% of your take-home pay

This rule helps make sure that your budget can handle your car loan. Also, you won’t have to worry about owing more than the car is worth, which can happen when loans last too long.

This rule says that if you take home $4,000 a month, your total monthly car costs, including loan payments, should be $400 or less. For a 20-year loan, that means borrowing no more than $14,500 for a $20,000 car with a down payment of just 10%.

Watching Out for Long Loans

Car loans with terms longer than 5 years are not recommended by experts because they raise interest rates and the chance of losing equity. When you owe more on a car than it’s worth, it’s hard to sell or trade in.

Yet 7-year loans are increasingly common, enabling consumers to buy more expensive vehicles while keeping monthly payments low. But stretching out the loan term means you’ll ultimately pay thousands more in interest, and remain “upside down” on the loan for years.

Minding the Interest Rate

Today, the average rate for an auto loan is around 6% for people with good credit. But rates over 10% still exist, even for prime borrowers. For dealers to make more money, they often charge higher interest rates on loans they set up.

Higher rates dramatically increase your total interest costs over the loan term. For example, $20,000 financed for 5 years at 10% costs over $5,500 in interest versus just $2,800 at 4%. That’s an extra $2,700 due to the rate hike alone.

Aim to secure financing below 5% from your own lender before visiting dealers, so you won’t be tempted by inflated rates they may offer. Preapproval also strengthens your negotiating position on the car’s purchase price.

Buying New vs. Used

Since new cars depreciate rapidly, it’s generally smarter to buy used if you want to avoid negative equity. After just one year, a new car typically loses 20% of its value. Your loan balance will exceed the car’s worth during the first couple years unless you made a large down payment.

With a 1- or 2-year-old used car, the first owner absorbs most of the depreciation. You’ll owe less than the car is worth over a shorter loan term. This also reduces the financial impact if your car gets totaled in an accident soon after purchase.

Factoring in Insurance and Fuel

Aside from the purchase price, insurance and fuel costs also rise quickly with more expensive vehicles. Make sure to account for higher insurance premiums in your budget if upgrading to a pricier or sportier car. Fuel costs obviously vary by vehicle mileage and efficiency as well.

Limiting your transportation expenses to under 20% of take-home pay is prudent. Don’t let an eye-catching luxury model tempt you into a payment that strains your budget.

Avoiding Predatory Lending

Some subprime lenders prey on consumers with poor credit through deceptive tactics:

• Teaser rates that later soar to 20% or higher.
• Balloon payments required after a few years.
• Extremely high fees tacked on to the loan amount.

Walking away from these predatory loans is usually the smartest move. They are designed to benefit the lender, not the borrower. Find an affordable used car you can buy with cash instead until you can improve your credit.

Considering a Shorter Loan

If possible based on your finances, opt for the shortest loan term you can manage comfortably. You’ll save substantially on interest costs over just a couple extra years.

For example, $20,000 financed for 48 months at 5% costs $1,817 in interest. Stretching to 60 months costs $2,538, which is an extra $721. Paying more toward principal when you’re able reduces interest fees.

Maintaining Good Credit

Having excellent credit in the 700s will qualify you for the best auto loan rates. Pay all bills on time, keep credit card balances low, and correct any errors on your credit reports. Shop around with multiple lenders to find the most competitive rate.

While 0% financing offers are enticing, calculate the total interest cost if you plan to carry a balance beyond the promo period. Rewards cards with moderate rates may cost less long-term than deferred interest deals.

Summing It Up

To avoid having too much car debt:

• Assess your total debt load and reduce other debts first if needed.

• Make at least a 20% down payment and keep the loan under 5 years.

• Compare loan rates from banks/CUs and resist dealer markups.

• Buy used and keep the loan balance below resale value.

• Account for higher insurance and fuel costs in your budget.

• Beware of predatory lending tactics.

• Pay down principal faster if you can afford extra payments.

Sticking to these guidelines will help ensure your new car doesn’t become a debt burden down the road. Carefully consider what you can realistically afford based on your income and expenses.