By Joel Chouinard, ChFC®
June 6, 2024
If you’re anything like me, the car-buying process can be a roller coaster of emotions. From the excitement of the initial test drive and the smell of new leather, to the paralysis by analysis of doing the research, to the frustration and anxiety of the negotiations. But once that initial rush of emotions is over, you start seeing your car as a useful tool that can take you from point A to point B safely. The issue is many of us get caught up in the emotions of buying the car, and we end up making costly mistakes. In this article, we’ll dive into five crucial financial mistakes to avoid when buying a car, which, in turn, means more money in your pocket and less stress.
1. Spending More Than 10% of Your Take-Home Pay on Car Payments
It's tempting to splurge on that luxury model with 22-inch wheels and the latest technology, but the rule of thumb is to spend no more than 10% of your take-home pay on car payments. If you are a couple and have two cars, the total of your two car payments should be under 10%.
The 10% limit also aligns with the 50/30/20 rule—where 50% of your income should go towards necessities, 30% towards discretionary items, and 20% towards savings. If you consider that no more than 28% of your net income should go towards your housing expenses (mortgage, property taxes, and insurance), this leaves 12% for all other essential expenses, such as utilities, groceries, childcare, etc. (50% minus 25% for mortgage minus 10% for car payments equals 15%). For instance, if you're taking home $15,000 per month as a family, then no more than $4,200 should be spent on housing expenses and no more than $1,500 on car payments, leaving $1,800 for all other necessary expenses.
For car enthusiasts, it might be difficult to keep the payments under 10%. If that’s the case, just make sure the extra dollars above the 10% guideline come from the discretionary bucket (30%) and not the savings bucket (20%).
2. Getting a Long-Term Loan (72 or 84 months)
While a longer-term loan might seem attractive due to the lower monthly payments, it’s essential to understand the implications of car depreciation. Cars lose value quickly. On average, they lose 20% of their value in the first year and up to 60% of their value within the first five years.* Therefore, spreading payments over 84 or even 72 months can lead to situations where you owe more than the car is worth—a term known as being “upside down” on your loan. For example, purchasing a $60,000 car with an 8% interest rate over 84 months means you’ll pay over $78,000 by the end of the term, significantly over the car’s value. This especially becomes problematic if you want to sell the car before the end of the loan term, and you owe more than what the car is worth.
If monthly payment affordability is a concern, consider putting a larger down payment or choosing to lease, which often requires less commitment and lower monthly costs.
3. Not Considering Future Resale Value
The future resale value of your car is a critical consideration for whether you plan to lease or finance. On one hand, the resale value directly impacts your lease payment. Lease payments are calculated using several factors, including the residual value, which is a set amount determined by the leasing company that shows how much your car will be worth after depreciation at the end of the lease term. Furthermore, the resale value of the car, among other things, determines the residual value. Therefore, the higher the resale value, the higher the residual value, which means a lower lease payment. On the other hand, if you finance your car (or buy it cash), the higher the resale value, the more you can trade in toward your next car, thereby reducing your next car payment.
Also, cars known for their dependability tend to hold their value better and usually come with lower maintenance costs. For example, brands like Toyota and Honda traditionally have high resale values because of their reliability.
4. Not Taking Time to Negotiate the Price of the Car
Many buyers are hesitant to negotiate the price, especially when they are financing or leasing. I get it. I don’t think there’s anything in life that gets me more anxious than walking into a dealership to negotiate a car (hence why I leave that job to my lovely lawyer wife). However, the listed price, or MSRP, is often just a starting point. MSRP stands for Manufacturer’s Suggested Retail Price, so it is by no means the final price like what you would see for an item at a grocery store. By negotiating, you can significantly lower your costs. This applies to all aspects of the purchase, including accessories, extended warranties, and prepaid maintenance plans. Even small concessions from the dealer can result in savings over the term of your loan or lease.
5. Overlooking Other Financing Options
Typically, dealerships offer their own financing options, but these may not always be the best deal available. Banks, credit unions, and other lending institutions often provide competitive rates that can save you money in the long run. Exploring all available financing options, including less traditional ones like personal loans or home equity loans, can provide additional flexibility and possibly lower interest rates.
Final Note
Navigating the financial landscape of buying a new car requires careful planning and an awareness of potential pitfalls. By steering clear of these five common mistakes, you can confidently purchase your next car knowing that it won’t put a strain on your finances. This should enhance your overall satisfaction with your new vehicle and make you feel great about driving it off the lot!
* https://www.kbb.com/car-advice/how-to-beat-car-depreciation/
SharpEdge Financial LLC is a registered investment adviser registered with the State of Texas. Registration does not imply a certain level of skill or training. The views and opinions expressed are as of the date of publication and are subject to change. The content of this publication is for informational or educational purposes only. This content is not intended as individualized investment advice, or as tax, accounting, or legal advice. Although we gather information from sources that we deem to be reliable, we cannot guarantee the accuracy, timeliness, or completeness of any information prepared by any unaffiliated third-party. When specific investments or types of investments are mentioned, such mention is not intended to be a recommendation or endorsement to buy or sell the specific investment. The author of this publication may hold positions in investments or types of investments mentioned. This information should not be relied upon as the sole factor in an investment-making decision. Readers are encouraged to consult with professional financial, accounting, tax, or legal advisers to address their specific needs and circumstances.