As a financial planner, lots of people come to see me looking for help with their budget. Most of the conversations go pretty much the same. “We don’t do a lot of extravagant things or buy a lot of stuff, but we just don’t seem to have any money to save.”
I usually start by asking “What are your car payments?” For people who don’t have any other obvious issues, car payments can often be the answer.
The sneaky thing about car payments is that no matter what budgeting concept you use, they hide away. Some people will tell you to list your fixed expenses versus your discretionary (non-fixed) expenses. There are the car payments hiding under the fixed column. Other budgeting styles have you list your needs versus your wants. Again, there are the cars tucked under the “needs” heading. So while you stare vainly at the discretionary spending or at your wants spending, the problem lurks on the other side.
My Car Isn’t Expensive
Right now, you are thinking, “I don’t drive that expensive of a car.”
Ever notice how many car commercials there are on television? Whether you are watching the Super Bowl or the Oscars, Grey’s Anatomy, Deal or No Deal, American Idol, or House, you will see dozens of car commercials. As you watch those commercials you can get a very skewed idea of what is a “normal” or “average” car.
Take a couple earning $100,000 per year. They are doing pretty well right? It’s $8333 a month. Figure that works out to a take home pay of around $6000 after taxes and insurance premiums and so on. Let’s say they are a savvy couple and they were smart when buying a house. A $2,500 mortgage wouldn’t be any sort of a stretch. That leaves them $3,500 a month to live on. Not bad right?
Now let’s say that he has a car payment of $550 a month and she has a car payment of $450 a month. How about now? They have $2,500 a month to live on now. Car insurance, cell phones, internet, gas, groceries, utilities, ice skating lessons, band camp, day care… and all of the sudden a couple making six-figures has no money.
The hard part of this conversation is that neither one drives an “expensive” car.
A car that cost just $30,000 with a 5-year loan at 7% works out to almost $600 a month for a car payment. That’s not a Lexus! That’s a regular Honda or Ford or whatever.
A $500 a month car payment works out to $6,000 a year. For the couple above, that $500 payment represents 6% of their total income and that’s just for one car — PRE-TAX! If the the couple pays $20,000 in total state and federal taxes (a ballpark figure) then that payment actually represents 7.5% of their disposable income. Don’t forget, a couple usually needs two cars, so two $500 car payments eat up 15% of their annual income. Is it any wonder their budget seems tough to figure out?
How Much Is Too Much?
Loan guidelines suggest that a house payment should not exceed 30% of take-home pay. If a house is supposed to cost 30% how much should a car cost? Half as much? A quarter as much? Realistically, somewhere in the neighborhood of 10% would be a solid limit. Our couple above has $6,000 in take home income, so their total car payments should be under $600 total. Anything higher means plenty of head scratching come budget time. So, two $300 payments, or one $600 payment. If you want nicer cars, buy them less often. If you want newer cars, buy lower priced ones. Don’t even think about going over 20% unless you want to be worried about money every month.
Protect Your Budget
So, how do you keep from falling into this trap? If you like the car, go online to a neutral site like MSN or Edmunds and get a price. Don’t pretend you are going to get some super-low negotiated amazing price deal. Just go with the regular MSRP for now. Take the price and plug it into a loan calculator at 7%. See what the monthly payment is. Too high? Then it is probably time to find a different car to buy.
Another option is to buy used. A new car loses up to 20% of its value in the first year alone. Look for a used one-year old model or a two-year old model. A good bank or credit union will still give you a 5 year loan at the same interest rate (or within 0.25%) of the new car rate. If the lender offers you any other deal, go somewhere else. There is no reason you can’t get a 5 year loan at about the same rate on a 1 or 2 year old car. This will help keep your payment a little lower.
If you are within striking distance of paying off one or both of your car loans, do it, and then keep that car. Don’t buy another one, used or new. See how much more room there is in your budget when you don’t have a $500 car payment. If you get both cars paid off you’ll have $1000 more every month!
Upside Down
When you owe more money than the car is worth, it’s called being “upside down” in your loan. Don’t fall for the trick of getting out of your loan by buying a new car. All that happens is that your old negative balance gets rolled up into your new loan making your payment even higher, and guaranteeing that you will be upside down for even longer in your new car. For example, if you have 3 year old car, your car is probably worth less than you owe because the value of the car drops so fast the first couple of years. The car you bought for $25,000 is worth $18,000 but you’ve only paid off $4,000. So, you are upside down to the tune of $3,000. When you buy a new car for $30,000 your loan will be for $33,000. One year later your $30,000 car will be worth $26,000 and you’ll be upside down almost $7,000! It is a vicious cycle that too many people get caught up in.
Good luck. Your budget will thank you.
I’m planning to buy a car, already have a mortgage. This blog post is a real eye opener for me..!! I’ve read so many documents over the internet, nothing comes close enough to clearing my doubts, this post answered all the questions. Now I exactly know what to expect and plan accordingly. Thank you so very much.