Here's How to Know How Much Car You Can Afford

Buying a new (or new to you) car can be exciting and fun, but it's also a big financial decision. And those car payments can follow you for years, making it harder to buy a home, invest money for the future, or even change jobs. (You'll have to afford that car payment, after all!)

So, how do you figure out how much car you can actually afford? Generally, your total car costs shouldn't exceed 10% to 15% of your take home pay. That means if you make $60,000 but pay for insurance and invest in your 401(k), your take home is likely around $3,000 per month. So, you might think you can afford $300 to $450 per month in car payments.

Take that number to the car dealership, though, and they might tell you can afford just about any car! How lucky for you. But that's because the length of the loan can be extended to meet your monthly payment requirements -- and it also means you'll pay a ton more in interest.

Here's a better way to tell what cars you can actually afford.

Use the 20/4/10 rule

The 20/4/10 rule is a good rule of thumb for figuring out how much car you can actually afford. This means you should be able to put 20% down, finance the car for no more than four years, and keep your total monthly car costs, including car insurance and car payments, below 10% of your monthly income.

Using this rule, you can figure out how much car you can afford. Let's say your monthly gross income is $5,000, which means you should spend no more than $500 per month on car expenses. Then, let's drop our estimated monthly payment to $400 to account for the cost of insurance, registration, and so on.

Now, let's assume a four year loan payment, which is 48 months. So, we'll use the formula:

Maximum monthly payment x 48 = Estimated loan amount

Based on our 10% rule, that means:

$400 (maximum monthly payment) x 48 (car loan term) = $19,200 (maximum loan amount)

Then, let's find out how much we'll put down by finding the down payment.

Estimated Loan Amount / 0.80 = Car Price

Note: We don't just add 20% to $19,200 because we're assuming the loan amount will cover 80% of the price of the car -- hence the 0.80.

Based on our numbers, this comes to:

$19,200 / 0.80 = $24,000

All this back-of-the-napkin math means you can afford a car that costs around $24,000. But there are a few other factors to consider.

Find out your interest rate

The average interest rate for a car loan is between 6% and 10%, depending on your credit score. If you have a lower credit score, you can expect your interest rate to be as high as 12% to 18%.

For example, let's say you purchase a car with a loan amount of $19,200 at an interest rate of 12% and finance it for 48 months. A handy car loan calculator tells us your monthly payment will be $506 per month, and $192 will go to interest in that first month. The amount that goes to interest will fall over time as you pay down the principal, but your car payment will remain the same.

This was not factored into our calculations above, because rates can vary so much by person. For ease of calculation, expect to pay between $100 to $200 a month in interest, so consider dropping your ideal loan payment by at least a hundred dollars to account for this difference.

Shop around for car insurance

Car insurance rates can vary drastically by insurance company and by car. You'll pay a lot more to insure a 2024 Ford Mustang than you will to insure a 2000 Toyota Camry. Make sure to shop around for insurance plans and find one that fits your needs and your budget. Drivers who can't afford to replace a vehicle should buy full-coverage insurance.

Final thoughts

Don't let the excitement of getting a new ride blind you to what you can actually afford. Use the 20/4/10 as a rule of thumb, but stay on the conservative side by dropping your ideal monthly payment a bit. This will leave you with money to save or invest, setting you up for long-term financial success.