How Much Car Can I Afford?

The average new car costs $40,720, while the average used car costs $29,983 according to the latest iSeeCars data. While used cars are significantly cheaper than new cars, both are still a major expense. That’s why it’s important to set a realistic budget and determine how much money you can afford to pay for your new -- or new to you -- car. We have the answers to help you determine that age-old question: how much car can I afford?

1. Determine Your Credit Score

Unless you’re paying for your car in full, you’ll need to secure a car loan. The first step toward getting a car loan and figuring out how much you can afford to pay is determining your credit score. This can also be referred to as your “FICO score” and is a numerical representation of your credit history. The three major credit reporting agencies – Equifax, Experian, and TransUnion – can each provide you with your FICO credit score. Another option is to check with your bank or credit card companies. Many of these institutions also provide a free credit monitoring service that will tell you your credit score.

A credit report, as well as monitoring services, also include a record of your credit history, including any items that are lowering your credit score. The higher your credit score, the better loan term you will be able to secure. Car manufacturers and dealerships will advertise special payment terms like zero-percent financing, but it’s important to remember those terms typically only apply to buyers with favorable, if not top-tier, credit scores.

If your credit score is low, you should try to boost your number before you purchase a car. You should aim for a credit score of 680 or above, but higher is always better. You can start by making sure you make your credit card and loan payments -- especially any auto loan payments -- on time. Resolve any past-due accounts, and pay down as much of the balance on your loans as you can, especially revolving credit accounts. You should also avoid opening new accounts, as frequent inquiries to the credit bureaus seeking new credit can lower your credit score.

While a good credit score isn’t required to secure a car loan, it will afford you a better annual percentage rate (APR) on the interest you’ll have to pay. The higher interest rate you have, the more you will end up paying in the long run. If you are unable to achieve a favorable credit score, another option is to get a co-signer on your loan. Your co-signer will agree to make loan payments if you default on your loan, which can lower an otherwise high interest rate.

2. Determine Your Down Payment

Making a down payment will lower the amount of the loan, or principle, you will need to take out, which will reduce your monthly payment. This also reduces the overall interest you’ll pay on the loan over time. While this can help make a car easier to afford, don’t deplete your savings account. Be sure to keep enough money on hand for whatever surprises might come your way. Dealers and lenders may offer deals for zero down payment financing, but you can still put money down to shorten the length of your loan and reduce your monthly payment.

3. Estimate the Value of Your Trade-In

The process of trading in your car begins with determining how much your car is worth. Major factors that impact your car’s value include how many miles it has on the odometer and its overall condition. Having your vehicle professionally detailed can also boost the trade-in value for your current vehicle.

Several websites, including Edmunds (Edmunds.com) and Kelley Blue Book (kbb.com) have valuation tools that will give you a ballpark estimate on the value of your car. Make sure you are as honest as possible in answering any questions about your car’s condition. Some valuation tools offer an estimate specifically for trade-in value, but that’s just what it is – an estimate.

You can also sell your car to a private buyer, which will be more profitable than trading your car into a dealership. In this instance, you can price your car in accordance with its market value, which is higher than your car’s trade-in value. A car’s trade-in value is the amount of money a car dealer will offer you for your vehicle, whereas market value, also referred to as private party value, is the amount of money you would get selling your car directly to a buyer. Because dealerships handle the complex process of selling the vehicle, they offer a lower trade-in value to ensure they make a profit when they sell the car.

There are helpful online tools like the iSeeCars Price My Car Tool, which provide a detailed pricing report to help calculate your used car’s value. Simply enter your vehicle’s VIN or provide its make, model, year, trim, style, and mileage.

Whether you decide to sell your car privately or trade-in at the dealership, you can apply your car’s value toward the purchase price of your next vehicle, along with your down payment if you’re making one.

4. Calculate Your Car Budget

Setting a monthly budget will guide your new or used car search. As a general rule of thumb, your car payment should not exceed 10 percent of your monthly income, and your total car expenses (fuel, maintenance, car insurance, registration) should not exceed 15 percent of your monthly take-home pay. Or, if you’re paying in cash, determine the amount you’re willing to pay for your vehicle. You can use the 15 percent rule as a guide, but if you have other major monthly expenses like student loans, you should determine a monthly payment you can comfortably afford.

5. Determine Your Car Loan Amount

After you determine your monthly payment amount, you can determine how much you can borrow from a lender. One way to do this is by obtaining a pre-approval letter from a financial institution, which will review your credit history to determine how much money they will loan you. Keep in mind that you might be pre-approved for more than you can afford, so make sure you stick to your budget. You can also use a car affordability calculator, which is available on many personal finance websites, by entering your credit score, estimated monthly payment, and desired loan term. Remember -- the shorter your loan term, the less you will pay in interest over time. Don’t be tempted to stretch out your loan term in order to have a smaller monthly payment, because you’ll end up paying more in the long term. For example, if you purchase a $25,000 used car and put $4,000 down with an interest rate of 4.5 percent, your monthly payment on a four-year loan will be roughly $625 and you will pay $1,488 in interest over the duration of the loan. If you spread the loan out over five years with a higher interest rate of 5 percent, you will pay roughly $396 per month and nearly double, $2,778, in total interest. While a smaller monthly payment might seem appealing, it will cost you a lot more in the long run.

It’s important to note that most lenders will not provide a loan on a vehicle that’s more than five years old, so if you are relying on the financing you should consider a later model used vehicle.

6. Shop Around fr the Best Loan Rates

??You should always visit a bank or credit union to get pre-approved for a loan before you go to the dealership. Even if you plan on securing an auto loan through the dealership, having a pre-approval option from a financial institution can help you negotiate against the dealer’s rate. It will also show them that you are a serious buyer, which will give you more bargaining power. Because dealers make more money on vehicles they finance, they will likely try to beat the rates you’ve already secured.

7. New or Used?

When purchasing a vehicle, you have the choice of buying a new or used car. Although they are more expensive, there are perks to buying a new vehicle, including peace of mind, the reduced likelihood of unexpected repair bills, and warranty coverage. New cars also typically come with lower interest rates and financial incentives.

According to an iSeeCars study on off-lease car deals, the average used car loses 39 percent of its value after three years. When you buy a used car, the largest percentage of depreciation has already been absorbed by the original owner, and you get the car at a much lower price. You can even buy a car that is just one year old, which will typically cost 17 percent less than its new version. However, in today’s market, some lightly used cars cost more than their new versions, so be sure to compare the cost of new and lightly used vehicles. You may find that buying a new car is a better financial decision than purchasing a lightly-used one.