how much should I spend on a car?

Written by Glen James

Host of the money money money (formerly my millennial money) & Retire Right podcasts & author of The Quick-Start Guide to Investing.

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So you’ve decided it’s time to upgrade from your trusty old car to something newer and flashier—congratulations!

But before you dive into the details of your next vehicle purchase, it’s crucial to get a handle on your budget. Here are my tips to guide you through the process so you work within your limits, and ensure that the car doesn’t destroy your long-term financial plans.

how much should I spend on a car? And should I get a loan for it?

Like anything related to personal finance, it’s personal – everyone is unique and different. But here’s my TL; DR answer to your questions:

• Don’t have more than 50% of your annual take-home income in stuff with motors

• Never take a finance term for more than 4 years

• Put a 20% deposit down (or as much as you can!)

• The sweet spot is a car that’s 3-4 years old with less than 60,000km on the clock (pending world events/market heat/supply and demand shifts)

• As a guide, keep the monthly payment amount around 1% of your net income (see example below)

• Be reckless and pay cash for the whole car if you have the money saved

• Generally, I don’t recommend getting loans for a car (I will explain why)

• Safety and warranty aren’t really reasons to buy only brand-new cars

the golden rule – 50% of net annual income

First and foremost, you should not have more than 50% of your net annual income tied up in things that are going down in value (cars!), things with a motor (boat), or toys (motorbike).

For example, if your take home (net) annual income was $60,000 your limit is $30,000. So, if you needed to upgrade your car and had a boat and motorbike worth, say $10,000 combined – you would spend a maximum of $20,000 on a car.

This is a good guide and can be used for most situations. 

You are also allowed to spend less than this (wink wink). You can get good quality second hand cars for under $10k.

No more than a 4-year finance term

Another must when borrowing money for a car is to never take a repayment term over 4 years. I have had friends borrow over 5 to 7 years. This lowers the weekly repayment (which you should never look at while at a car yard) and will get you a higher value car which you can’t afford. Also, 4 years is a long time in any case. If you’re anything like me, I want another car after 2-3 years as I just want a change. No other reason. If you put 20% down into each car you will be able to chop and change with less issues if you had to.

Unless you are using the vehicle for work purposes and can make a portion of the interest payment tax deductible and depreciate a portion of the capital value, I would not suggest getting a loan or lease scheme with a balloon amount at the end of the term. If you are, the 20% down again will help you at the end of the term.

Let me be very clear: 99% of the time a car will not make you money unless you are a collector and never drive it. Which is practically no one. Cars are a tool that we use for day-to-day life which decrease in value every single day. The funny thing is, you can’t get too caught up in the new designs as by the time you purchase a new car, I guarantee you the next design is almost ready, and you purchased the old style. Eww. Yuk. How could you!

Pro tip: don’t take financial advice from a car salesperson. Most car yards now are in the business of selling finance, not cars! They will want you on a 7-year term.

put a 20% deposit down

I would recommend putting up to 20% of the purchase price down when you take a car loan – of any type. This will ensure that if your circumstances change throughout the loan term and you need to offload the car – you will not owe more than it’s worth. If you were purchasing a $20,000 car, I would suggest saving around $4,000 toward the car. You’ll thank me later. If you can't do 20%, please do put some money into it.

the sweet spot – a car that is 3-4 years old

Although the car market can be impacted by world events, supply and demand, and temporary heat, I believe the sweet spot for a car purchase if you are thinking of buying "new", is 3 years old with less than 60,000km’s on the clock. This is how I purchase my cars.

Cars lose up to 60% of their value in the first 4 years. This is ever increasing with the rise of Chinese and other Asian cars being imported and selling brand new for cheap with the lure of 7-year warranty. This in turn makes second hand cars so cheap and conversely new cars fall off a price cliff so much sooner. A lot of these warranties are now transferable, so you don’t need to buy new to have this!

keep your monthly repayment around 1% of your net annual income

This is also a good little guide to keep you safe from harm. If your net annual income was $60,000, you can spend up to $30,000 on a car (not new, but ex demo or up to 3 years old!). 1% of $60,000 is $600. You’d want your car payments to be around this $600 per month, on a 4-year term, if you borrow money for your car. 

Example:
If you were to borrow $30,000, the personal loan calculator on an online lending site tells me the monthly repayment would be $780 (based on a 9.95% interest rate) over 4 years (48 months). Once we apply our savings to meet the 20% rule or $6,000 down on the car, it means a $24,000 loan. The amount for the same term and interest rate reduces to $628 per month. If you take this to $23,000 - you would be under $600 - so maybe negotiate your buy price!

These percentages are guides to keep you in the ballpark. 

four popular loan types

Personal loan – a loan given to you with no security behind it. If you can't pay, the lender can't repossess anything from you. This will be the highest interest rate as the lender has less chance of getting money back if you can't pay.

Car loan – a loan that has the car as security for the lender. If you can't pay the lender will legally repossess the car back, sell it and any leftover monies owing? Well, they will chase you for it. This has a lower interest rate than a personal loan and some lenders may not want cars older than say 4 years when you apply.

Home mortgage – some people will redraw off their home loan to buy a car. This is the cheapest form of borrowing as the security is an appreciating asset and the borrower is seen to be reliable. If you don't pay, it's simple - the lender will just take your home. If you are doing this, do not just redraw from your existing facility. See if the bank can set up a different mortgage for this - so you can still smash it in less than 4 years as opposed to paying it off over the next 10.

Leases – these are a more complex instrument which can have a lower interest rate than car loans depending on the person who takes out the loan. I.e., if they are a homeowner or not. Hire purchase, novated lease or chattel mortgage are the common types and you should speak to your accountant before committing to these. They are generally more beneficial for a business owner. These leases would have the function for a balloon at the end of the term. I wouldn't suggest more than 25% and my criteria would still apply for these arrangements (term, value, repayments etc).

what to watch out for with car loans

However, having listed these 4 options, I’m not a fan of taking on car loans. Here’s why.

The problem with a car is that as soon as you drive it out of the dealer’s car yard, click the seatbelt on and drive away, the car is likely to be worth less than the amount you borrowed for it —and that’s not even considering the interest you’ll pay over the loan term. In addition to that, the vehicle will decrease in value every single day.

Not only are you getting screwed from day one in terms of the amount you owe versus the car’s depreciating value, but you’ve also given yourself no psychological pressure or resistance for borrowing to purchase it, which can amplify the negative financial effect.

For example, paying $18,000 upfront for a car might be a lot of money for you, but $92 per week sounds very doable. If we lived in a world that didn’t have car loans, you probably couldn’t stomach saving up that much money and transferring it in one transaction to an item that will immediately decrease in value, and possibly be dinged and treated like crap (I’ve seen how some of you look after your cars!).

I used to be hard-line with my view on car loans. When it comes to getting your habits and behaviours sorted, I would prefer that you try and change your other major money habits first rather than me insulting you and turning you off by saying you can’t have a near-new or brand-new car that stinks of plastic and toxins curing (I mean, that ‘new car’ smell). I’d rather win the war with your total financial picture as opposed to losing a battle on cars.

You’re likely to end up paying less for a car that you pay cash for due to the psychological hurt from the process of coughing up $18,000 of savings. You might decide that $10,000 is more reasonable and that you can invest the rest and make it grow.

Pro tip: never buy a car based on the “per week” price, advertised at the car yard. “but it’s sooo cheap!” Yeah, shut up, you are going to get ripped off!

why not be reckless and pay cash?

You could always save cash and buy a car outright. Crazy right? Still use the 50% rule and buying up to 3 years old if you are buying "new". If you want quality and value, head to Japan. Simple as that. Popular Japanese makes are Toyota, Mazda, Honda, Subaru. If you get one of those makes, they have the history and track record to prove themselves and the service costs are not astronomical. 

warnings about luxury vehicles

At one time I owned a 2013 Lexus (Japanese, owned by Toyota) IS350 Sports Luxury and there was no dealer close to me. I made the unfourtunate mistake of running into the back of a lady in her Range Rover, ouch. I had to go to the dealer to get the adaptive cruise control re-calibrated after it was repaired. Total damage: $25,000.

It was also a 1.5-hour drive to the closest dealer so such a pain. Getting a luxury car is also a pain as the repairs took almost 9 weeks because they had to get uncommon parts from Japan. I was significantly out of pocket with hiring cars as my insurance company at the time only gave me a hire car for 2 weeks. Further to the annoyance, due to the damage being over $8,000 they had to send an assessor to the repair shop and that almost took 2 weeks alone.

These are the considerations you need to be aware of when wishing to purchase something a little sexier and premium. Anyway, the only good thing is I got a brand-new Lexus loan car while they serviced mine! But I did pay for that, as the basic service cost me $727. Never again! It was due for a service, and I thought it would be convenient while it was getting worked on anyway.

don’t get caught in the brand-new car trap

The most common thing I hear from every second person who wants to get a brand-new car is about safety. The logic is garbage - it concludes that a 3-year-old car is not safe, only brand-new is safe. You can get a safe 10-year-old car. If this is the case and you use this to justify your car purchase, you would have to buy a new car every single year to maintain your stance. Now that's not going to happen, is it! Get a 3-year-old car, save thousands of dollars, and get on with your life.

Other emotional garbage I hear to justify stupidity, I mean, the purchase of a brand-new car is the "warranty". Warranties are transferable. Also, I generally service my cars at the local mechanic, and this does not void warranty. I have had a warranty issue with a steering rack on my Ford Focus, which I purchased second hand, and Ford still fixed it even though it was never serviced by them. Plus, at least if you buy something a year old most of the time anything that's going to break would probably already have broken.

As a final guide, it's probably OK to buy a brand-new car if you have a net worth of over $1m, as you can afford to take the financial hit. I would still use my 50% rule (value) 1% rule (repayment) and 20% rule (deposit).

Finally, always remember that new car smell is the delicious toxins leaving the plastics :)