Making Cents: How Much to Spend on Your New Car

Doug, you wanted to take this opportunity to not only give us an update on the cash for clunkers program, but also share some of your concerns.

Lowman, I don’t think most people realize how much of their wealth gets flushed down the drain while owning a car. My fear now is with the additional $2 billion for the cash for clunkers program, many people who previously may not have considered trading in their clunker, may do so now even though for them it makes no financial sense. I mean if you’re driving a clunker, usually there’s a reason.

From my experience as a financial planner, if there’s one thing I see more than anything, its people who are spending more on their cars than what they are saving for retirement. Without fail, whenever someone says to me, "Doug, I don’t have any extra money for my retirement", you can almost always count on significant car payments when digging through their monthly budget. Cars are expensive, they depreciate in value rapidly, need maintenance, need gas, and you have to insure them. The total cost of owning a car is much higher than most people think. But, it’s something they can control.

So with all this media attention focused on the cash for clunkers program, I wanted to take this opportunity to give your listeners some tips before they catch car fever and buy more car than they can afford.

Before we to get those tips, can you give us an update on the cash for clunkers program.

Well, it ran out of money. That means either it was a huge success or the government simply overpriced the clunker voucher. As with any government program, there are unintended consequences. But the hope is the program will generate some 750,000 new vehicle sales and help clear out inventory before the 2010 models arrive in the fall. So far, the program has been a boon to the auto industry and a great bargain for consumers.

Remind us how the program works?

Your clunker must be 25 years old or newer, get less than 18 mpg, be in drivable condition and insured in your name for at last one year. You get either a $3,500 or a $4,500 voucher, depending upon the increase in mileage per gallon in clunker to new car. To learn more about the program, go to www.cars.gov. To find out if your clunker meets the fuel economy requirement, go to www.fueleconomy.gov.

Talk about buying a new car. What do you recommend people do?

First, understand the impact of having too big a car payment. For example, the average car payment in the U.S. is around $400 a month. If instead of having that car payment, say you invested $200 of that money into your 401k and then saved the remaining $200 to buy a car for cash every 8 years. The result: you’d have no car payment, no finance charges, and after 40 years you’d have around $750,000 extra in your 401k, assuming a 6% rate of return.

Here’s a rule of thumb: if your total car costs exceed what you’re able to save, you have more car than you can afford. In other words, if you’re paying $400 a month for your car but can’t come up with $400 to save in your 401k, you’re in trouble. That’s why you want to make sure you’re keeping your car costs as low as possible so you can focus on building wealth.

Now I understand that cars wear out and that we will eventually have to get another one, but do you realize that the average family, over their lifetime, will put more money into their cars than they will put into their homes?

So can you give us some tips?
Sure. A big trap is thinking of a purchase as a payment instead of the actual price. When buying a new car, think about how much total car you can afford and what a reasonable payment would be for that car. Total cost includes car insurance, gas, and maintenance. Dealers and car salespeople are notorious for talking about how they can lower your monthly payment in order to up-sell you into something more than you need. The number one way they can make your payment lower is by stretching out the term of the loan, which in the end just has you shelling out more money towards interest.
Second, your car payment should be no more than 12% of your net take-home pay. If your household net income is $5,000 a month, you can afford a $600 car payment. That’s a $20,000 car if financed over 3 years at 6 percent.

What happens, though, is people want a more expensive car so they extend the term of the loan to 6 years, allowing them to buy a $36,000 car instead. Sure, the car payment is still $600 a month, but they just bought almost twice as expensive car. But the really sad ending to this story is that after they pay the car off, most people buy a new one. This just creates a vicious cycle of having to make a car payment every month for the rest of their lives and is a wealth destroyer, not a wealth creator.

I recommend doing the following: (1) keep the loan to 3 years (2) once the loan is paid off, keep the car for another 7 years (3) then save the freed-up car payment for your next purchase or tackle other financial needs like paying off credit-card debt.

Third, if you can’t afford a new car, don’t buy a new car. Buy a used car instead. If you can buy a used car just a year old, you could save thousands of dollars which translates to less interest when financing and a lower monthly payment.

Finally, get pre-approved for the loan. Check rates with your bank or credit union and see whether you would be approved for the amount you need. Remember, most dealerships and salespeople don’t make much if any money on the price of the vehicle. Most of their commission comes from the in-house financing and extras sold with the vehicle. If you can find a better rate and terms with another lender before going to the negotiation table you can omit that discussion almost entirely.

What about leasing a car?

The new clunkers program does allow you to lease instead of buy, provided the lease period is at least 5 years.

In my opinion, unless there is a short-term personal situation where a lease makes sense, most of the time, it’s not a good option. The biggest mistake is to judge the lease solely by the amount of the monthly payment, which can be manipulated. Dealers love to lease cars so they can get people to buy more car than they can afford. Also, lease agreements are full of small print like the residual value, the cost of wear-and-tear or putting more miles on the car than the lease allows. You’ll need to be aware of the details and many people just don’t take the time to do that.

At the end of the day, when you take a look at the numbers, in the short-term, while leasing may look appealing, the long-term costs are always higher than the long-term costs of buying. And since most Americans keep their cars on average for 7 years, leasing, in my opinion, doesn’t make financial sense for most people.