Don’t take out a loan or visit a dealership until you know what you can afford.
A quick answer to how much you should borrow for is “as little as possible.” But knowing what amount your loan should be will affect what car you shop for and how you plan your finances.
First, understand the 20/4/10 rule
As you’re saving up for a down payment and calculating potential monthly payments, keep the 20/4/10 rule in mind. It follows three basic numbers:
- Down payment of at least 20%
- Loan term of no more than four years
- Total vehicle expenses less than 10% of your monthly budget
Once you have these in mind, you can start to calculate how much you should borrow for your car — and what type of budget you need to keep things affordable.
How do I find out how much I should borrow for my car?
Follow these five steps to help guide you toward a number that keeps your budget intact.
1. Save up for a down payment
The most common rule of thumb is to have about 20% of your car’s value saved up for a down payment. For example, you should have $2,000 for a car worth $10,000 or $6,000 for a car worth $30,000.
Start saving for your down payment as soon as possible. By thinking about your down payment ahead of schedule, you’ll have plenty of time to figure out how much you should borrow for your car. How much you have saved already could influence how much you decide to spend on a car and ultimately borrow.
2. Create a budget
If you don’t already have a budget, now is the time to make one. Consider all of your monthly expenses, including both your regular bills like rent and your more flexible spending like groceries. If you already have a car payment, you can use this as a guide, but keep in mind that you should spend no more than 10% to 15% of your gross monthly income on your car. This includes the car payment itself as well as gas, insurance and maintenance costs. For example, if your monthly income after taxes is $4,000, the total amount you spend on vehicle-related expenses should ideally be less than $400.
3. Calculate a potential monthly payment
You can calculate your car loan payment by estimating the interest rate you’ll be charged or getting a preapproval from a lender.
Estimating your monthly payment can be handy when you first start looking into buying a car, but it has its faults. You won’t know what type of interest rate to expect, and you won’t know what the other terms of your loan might be — which can impact the amount you pay every month.
By applying for preapproval with multiple lenders, you’ll not only be able to put yourself in a better position to negotiate, but you’ll also know what interest rate you can expect. Some lenders may even present an estimated monthly payment that accounts for fees.
4. Determine a purchase price
After you have an idea of the monthly payment can afford, you can work toward determining a purchase price. But remember: This isn’t just the MSRP listed on the manufacturer’s website. It’s also the taxes, licensing fees and other costs that come with driving a vehicle home. You should determine your final purchase price with these in mind — and this will give you an idea of how much you should borrow.
What are the typical fees I should expect?
While the exact fees you’ll end up paying will vary based on your area and the car you buy, taking these into consideration can be a good starting point:
- Sales tax. Typically, taxes may cost 5% to 10%, but you should take your state, county and municipality taxes into account.
- Registration fees. You can estimate these by visiting your state’s DMV website.
- Processing fees. Yours will vary by dealership and state, but commonly it ranges from $100 to $400.
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What factors determine how much I can borrow?
Lenders may use these to determine your the final amount you’re able to borrow:
- Your credit score. This is usually the most critical component that influences how much you may be able to borrow. Lenders use your credit score — and credit history — to predict potential risk of a borrower.
- Annual income. Lenders consider your income when determining your ability to repay a loan. If a lender doesn’t feel that your income will allow you to repay a larger loan properly, it may only approve you for a smaller amount.
- Living expenses. Lenders want to be sure that your new car payment will fit into your budget along with housing costs, utility bills, credit card bills, student loans and other monthly bills.
- Your savings. How much you have in your savings account could be used as a buffer in the event you’re unable to repay a car loan with your normal income. If you have more cash savings, a lender may approve you for a larger amount.
Once you know how much you should borrow for your car, you’ll be able to compare car loans with the confidence that you’re not overspending. You might want to learn some tools to help you negotiate at the dealership and get a good deal.