In other chapters, we discussed the cost per mile for buying new cars, for trading in new cars after 5 years, for buying used cars, and for leasing. Buying cars that were 5 years old provided the best value in the examples given. However, we only looked at the cost per mile to establish value. The cost of owning a car goes beyond just the monthly payment to a lender. Cars, like homes, need maintenance and have operating costs and related expenses that can put pressure on your budget.
AAA puts out a study each year that highlights the average cost of ownership for various types of new vehicles. While the study results don’t provide granular detail by make and model, larger groupings by type tell a tale of their own. Small sedans showed the annual cost of ownership at $6,777 per year, while pickup trucks weighed in at $10,215 per year. The average for all vehicle types in the study came in at a cost of $8,849 per year – and that’s for one vehicle. New cars cost a lot of money, part of which is depreciation, which you won’t see in your monthly budget. A new car loses an average of about 60% of its value in the first 5 years, a cost you may not notice until you try to tap the remaining value by selling your car or trading it in on another vehicle. Other expenses range from fuel to insurance to maintenance costs.
If you finance a new car with a 5-year loan for $36,000 at current interest rates, you might expect to pay about $647 per month. Kelly Blue Book recently reported the average transaction price for light vehicles to be $35,742. However, if you do the math, the average cost of ownership according to AAA is $737 per month. The difference doesn’t allow for gas, insurance, and other obvious expenses but the discrepancy may be in the fact that most auto loans for new cars are now longer than 60 months. A longer loan term can make a car seem more affordable on a monthly basis, but depreciation is still chewing away at the car’s value quietly and creating more financial risk with a longer loan term.
Let’s assume that you decide against the longer-term loan and the risk that can leave you upside-down in the loan for a longer time. Instead, you stay with the 60-month loan with a cost of $647 per month. That’s your starting point. From there you’ll need to add fuel costs, insurance, registration and taxes, and maintenance costs.
On average, we drive about 15,000 miles per year. Choosing a more fuel-efficient car can save a massive amount of money over the course of a year. A vehicle that averages 25 MPG will consume 600 gallons of fuel per year whereas a vehicle that averages 35 MPG will consume 428 gallons of fuel per year. Gas prices fluctuate constantly, but at $3 per gallon, the difference between the two vehicles is $516 per year or $43 per month. If we assume that the car you’re considering gets 30 MPG, your annual cost of fuel at $3 per gallon is $1,500 per year, or $125 per month.
Auto loan: $647
Total monthly cost (so far): $772
Of course, we aren’t done yet. Nearly every state requires auto insurance and if you have a loan on a vehicle, the lender will require full coverage auto insurance, which includes collision and comprehensive coverage in addition to state-mandated liability coverage.
Coming up with an estimated cost for insurance can be tricky because so many factors are at play. Insurance rates vary by state and even zip code and individual factors like claim history, driving history, age, credit, and other factors can have a large impact on rates. In general, expect a newer car to have higher insurance rates than many older cars because the insured value of the car is lower. However, safety features of newer cars can counteract this difference. It really depends on the specific details and features of the car you’re insuring.
Recent estimates put average auto insurance rates at $941 but included liability-only coverage in the averages. If you have a loan, you’ll need full coverage. Averages also prove troublesome when you consider the wide disparity between insurance costs based on age, gender, location, and other factors. Consider using a higher-than-average figure to avoid surprises when estimating insurance costs and reach out to your agent for a detailed quote if you’re considering buying a vehicle. Let’s use $1,500 per year as an estimated insurance cost because a vehicle with a loan will require full coverage.
Auto loan: $647
Total monthly cost (so far): $897
We’re now up to $10,764 per year and that’s with a vehicle that gets reasonably good gas mileage – and we haven’t added the cost of maintenance yet. We’re also using what may be a low figure for auto insurance costs. If you convert that expense to hourly cost with a 40-hour work week, your new car is costing you $5.17 per hour from your after-tax earnings. The annual cost per mile is $0.72 per mile for this vehicle. By comparison, the IRS currently allows a mileage deduction for business-related mileage of only $0.545 per mile.
Most new cars come with a warranty of 36 months, with some offering a longer warranty. However, in most cases, the cost of routine maintenance and wear items like tires, shocks or struts, and brakes aren’t covered by the warranty. As the car ages, expect other car components to show their age and start needing repairs. AAA estimates the monthly cost of repairs at $99 on average. Choosing an auto brand that has more expensive repair costs, a car that requires more frequent or costly repairs, or even vehicle with tires that cost more to replace can all add to your costs. To keep things simple, we can use the $99 figure from AAA. Your actual expenses may vary, however, so you may want to budget a higher figure in your own estimates.
Auto loan: $647
Total monthly cost (so far): $996
We’re close to $12,000 per year in vehicle expenses using somewhat rosy scenarios like good gas mileage and assuming that your insurance rates aren’t too expensive. Add in the cost of tolls, parking, registration, taxes, the occasional traffic ticket, and other miscellaneous costs, and you’ve easily crossed $1,000 per month. Chances are that when you saw the advertisement touting that you could buy the car for just $500 per month (after a sizeable down payment), the other expenses – the true cost of owning a car – didn’t come to mind immediately. We’re only human and advertisers know which buttons to press to get us emotionally involved with consumer goods.
There are more rules of thumb for car affordability than you might imagine, with numbers for monthly payments spanning from 10% of your income up to 50% of your income. That’s too large of a range to be useful, so we can use a rule of thumb that’s time-tested and probably the way your parents or grandparents used to buy cars.
The 20/4/10 Rule
In our earlier examples, we didn’t use a down payment because it distorts the true cost of the car. However, using a down payment reduces your risk in the auto loan and lowers your borrowing costs. It also reduces your monthly payment. In years past, car buyers put down a minimum of 20% to reduce the loan amount and build some instant equity to combat depreciation. Most car dealers will encourage you to put down the cost of tax and tags at a minimum but may not require a larger down payment to finance the car. This may make the sale easier because you don’t have to put out much money but puts you in a precarious position; as soon as you drive off the lot and the car value drops by 9% (on average), you’re upside-down in the loan, which means you owe more than the car is worth.
The “4” in this rule of thumb implores borrowers to choose a loan length of 4 years or less. Cars are a rapidly depreciating asset and a longer-term loan can put you in a position where you are still making payments when the car is starting to need more expensive repairs. Over half of all car loans are now over 60 months, with up to 25% of loans stretched out to 7-year terms. A longer loan term lowers the monthly payment but can also require that you make payments for a long time before you have any meaningful equity in the vehicle. You can also expect to pay a couple thousand dollars in additional finance costs if you choose the longest term available. Interest rates will be higher, and you’ll be paying interest for a longer time. Choosing a longer-term loan can be a sign that you’re buying more car than you can afford.
The last part of this rule is the “10”, which refers to 10% of your gross income for car payments. Experts recommend that you include auto insurance in this figure as well. If you make $50,000 per year, this rule suggests that your car payment and insurance should not exceed $5,000 per year, or $416 per month. This rule alone puts many new cars out of reach, which may not be a bad thing. Cars are a terrible investment, and if you take the emotion out of car buying, you really don’t want to spend too much on a rapidly depreciating asset. With new car prices rising every year and depreciation constantly on the march, the more affordable decision is to purchase a reliable used car, a vehicle on which someone else has already taken the depreciation hit.
Let’s look at some examples to illustrate the 20/4/10 rule.
If you’re looking at a $30,000 price, you would need to put down 20%, or $6,000. If your car follows average depreciation rates, you can expect your vehicle to depreciate by 9% the moment you drive it off the lot and by about 20% within a year. Now you’re beginning to see the importance of putting down a cash deposit or using a trade in which you have equity equal to at least 20% of the purchase.
You also want a loan term of no longer than four years. We’ll explore some figures using a 4-year loan term shortly.
Your primary car expense, which includes your car payment and insurance, shouldn’t exceed 10% of your annual gross income. Earlier, we estimated insurance costs at $125 per month, which of course could vary. We’ll look at some scenarios for affordability at different income levels.
Because you’re putting down 20% on a $30,000 car, the principal for the loan is $24,000. You probably also want to prepay your tax and registration fees rather than roll them into the loan.
At a 4% APR, your loan payment for your 4-year loan will be $542 monthly. Add $125 for insurance to reach a total of $667 monthly, or $8,004 annually. To afford this car without pushing the limits of financial safety, your gross income should exceed $80,000. Using the 20/4/10 rule for car affordability, many of us are driving cars we can’t afford. As a technical matter, these households may be surviving, but they may also be feeling financial pressure in other areas, they may be accumulating debt, or they may be unable to grow their savings at a healthy rate. Nearly half of US workers earn under $30,000 per year.
Using this rule, let’s instead assume an annual income of $40,000. Quick math suggests that you can afford a $15,000 car, but let’s get a bit more accurate with the math. A $40,000 income gives you $4000 annually for your primary car expense, including car payments and insurance, which works out to $333 per month. A used car will usually cost less to insure, so we can estimate $100 per month for insurance costs. This leaves $233 per month for the car payment.
As it happens, a car that is $30,000 when new can probably be purchased for about $13,000 when it’s five years old and has about 75,000 miles. If you apply the rule of 20% down, you would put down $2600. With a 4-year loan at current rates, the car payment works out to $235, which is only two dollars per month outside of your budget. If your mileage use is average, you’ll put another 60,000 miles on the car while paying off the loan and own it outright when it reaches 135,000 miles. Most modern cars, if well cared for, will run at least 200,000 miles. For the remaining 65,000 miles (over four years of use), you won’t have a car payment and can use the extra money to pay for repairs as needed and to save for a down payment on your next vehicle.
If you need a car – and many people who own cars don’t – a used car presents the best value. Choose carefully, the goal is to buy a car that will last to maximize your value and limit the costs associated with repairs or early replacement. Remove emotion from the car buying experience. Instead, invest some time in research and choose a vehicle that will be reliable and will save you money over the long term.