How To Determine What To Spend On A Car Without Falling Into The Monthly Payment Trap

Every few months, a new headline emerges showing that the average car note monthly payment keeps creeping upward. In what most analysts consider an uncertain economy, new cars are becoming less and less affordable for the average buyer. Let’s talk about why monthly payments should, but also shouldn’t, be the focus when you are shopping for your next ride. 

Now, if you are in the “I only pay cash for my cars” camp, that’s a fine place to be. However, if you aren’t buying old and/or whacky stuff from Craigslist or Marketplace for cheap, and prefer newer, with modern features and a warranty, most people simply lack the thousands of dollars in liquid assets to spend $15,000 or more for a vehicle. Therefore, these buyers will need to finance a car loan and will have a monthly payment. 

Naturally, there is no shortage of online commentary, especially from “finance gurus” who will say things like: 

Are too many Americans buying cars they can’t afford to keep up appearances? Sure. Does that mean that financing a car is one of the worst financial decisions you can make? Not if you use your brain first and an old-school device called a calculator.

There is an old piece of car buying advice that says “never focus on monthly payments,” and this has some validity, because far too often a buyer goes to a dealership with a payment target only for the dealer to structure the loan and the deal in such a way where the monthly note is where they want to be, but the overall deal is a bad one. 

For example, if someone has a monthly payment target of $400 and is shopping for a Honda Civic with an MSRP of $25,745. On the surface, it seems that $400/mo should get you a pretty reasonable car. After some back and forth dealer tells the customer, “Good news, I was able to get you a payment of $401.27 on your new Civic.” The buyer isn’t going to balk over $1.27 per month over budget and signs on the dotted line. Except, in order to achieve that payment, the dealer had the customer finance this car at an eight-percent interest rate for a whopping 84 months! This person will pay almost $8,000 in interest and have a total cost of $33,706 over the course of the loan. 

This is why the “finance experts” say to look at total cost first, which is not bad advice. Except that most people conceptualize their spending based on a monthly budget, and in doing so, they are looking at how affordable a car is through the lens of monthly payments. This is fine, as long as you do so before you go shopping for a car. 

Here is how you focus on monthly payments by working backwards and then determining the total cost. The first step is to take an honest look at your finances, money coming in and money going out via rent/mortgage, utilities, food, et cetera. You will then determine if you have a chunk of money you can allocate for your car payment. 

The next step is to know your credit score; there are ways to do this by checking all three reporting bureaus. Keep in mind that the score you see may not be exactly the same as the figure the banks see. Why this is the case is a mystery for the ages and one of the many confusing aspects of the credit system. However, you should have an idea of where your FICO is. Generally speaking, if your score is above 720, you are in good shape and you will usually qualify for competitive rates. 

Step three is to fire up a loan calculator that allows you to input the payments, loan term, and interest rate. In regard to the APR, that is going to take some estimation; if you happen to have a Tier 1 score (720+ FICO) you can safely use the “average” rates for new or used cars. If your score is below that, you will have to estimate the rate up accordingly. I recommend estimating on the higher side of APR for these calculations.

For some example calculations, let’s try to figure out what our budget for a car would be with a target payment amount $500/mo, assuming we have a Tier 1 FICO score. You need to set the loan term; sixty months or five years tends to be the sweet spot for having a reasonable loan term, but also allowing for a healthy budget. Shorter terms are fine if you like paying loans off sooner than later, but they will limit your budget if you want to stay under $500 a month. My recommendation is to go no longer than 72 months. You will also have to factor in your local sales tax, dealer fees, and registration. Fortunately, there are calculators that have those options as well. 

This is how I would go about setting a car budget: by starting with the monthly payments and then working towards the total cost. I would do this before I even start considering what cars to buy. I have my hypothetical target of $500 per month, I am going to set my loan term at 60 months with an estimated interest rate of six percent. I’ll set my NJ sales tax at 6.625 and put a rough estimate for dealer, DMV, and doc fees at $1000 (again, I like to err on the higher side). I also need to make sure I check the box to include all tax and fees in the loan. 

Plugging this into Calculator.net’s auto loan calculator results in a spending budget of $23,318 before tax, DMV, and fees. Pushing the loan term out to 72 months gives me $27,357 before additional charges. Now that I have an idea of what I can actually afford, I can start my research to see what cars fall within that budget range. Of course, if I were using a down payment, I could adjust my budget accordingly by whatever amount of cash I am comfortable spending. Bringing money to the table is always a wise decision, as it establishes some equity in the car and can prevent you from being underwater on your loan.

If this all seems like a bit of work, it is, but doing this is one of the most surefire ways to avoid buying more car than is appropriate for your finances. While there are plenty of dealers who won’t hesitate to rip buyers off, being armed with a clear and honest understanding of your budget and loan terms is one of your best defenses against a bad deal.