In general, people spend entirely too much money on cars. Everybody knows you should spend no more than a third of your income each month on housing. That’s why mortgage lenders usually only approve loans if the monthly payments are less than a third of the borrower’s monthly income.
But did you know that the credit bureaus say you should only spend 20 percent of your annual income on a car? That means if you make $24,000 per year, you should buy a car that only costs $4,800. Sound impossible? It’s not. There are perfectly good used cars out there for that price, and it’ll keep your monthly payments nice and low. Once you figure in car insurance, gas, repairs and maintenance, you’ll be glad you didn’t spring for a more expensive ride.
Why 20 percent?
You might think you can afford a more expensive car. If you’re pulling in more than two grand a month, a $200 payment is no big deal, right? Well, consider how long you’re going to be paying off your loan. What is your life going to be like four years from now? You might think that you know, but you can’t possibly know.
People get laid off. They have kids. They get sick or injured. They graduate from college. They get married. If a big life change happens to you, you’ll be glad you stuck to this rule. Buying a car that sucks up a big chunk of your income is how repossessions happen.
What if it’s too late?
If you have already purchased a car that’s too expensive and you are struggling to make your car payments, look into getting a refinance loan before it’s too late. Many people can qualify for a lower interest rate through a refinance loan. If your monthly payments are just too high, a refinance loan could extend the term of your loan to make them lower.
If you stick to the 20 percent rule next time you buy a car, it will help in the long run. Most people can comfortably pay off a loan for 20 percent of their yearly income in a couple of years. That means you won’t end up being upside down in your loan, and you’ll be able to hand on to your car longer than you hang on to your loan.