You want a new vehicle, but you don’t want to end up in repossession land because you can’t afford the payments. Fortunately, there is a handy little calculation (don’t worry, it’s easy) you can do to figure out whether it makes sense to buy or not.
The 1/10th Rule
A popular financial rule for buying vehicles is to not spend more than 1/10th of your income on a vehicle. For many, this naturally limits the selection a bit. All you have to do to find your cap is to add up your income for the month, and multiply by 12. Use net income (after taxes) for this figure. Then, take 10% of that figure.
This is the maximum amount you should spend on a vehicle. So, for example, let’s say you make $3,000 per month. That’s $36,000 per year. But, after tax, let’s say you only make $30,000 (a nice round number). 10% of that is $3,000. This means you should spend no more than $3,000 on a vehicle. Yes, the total price.
You’ll be surprised by just how many vehicles out there cost this much. There’s a lot of them. You can visit Cross Keys Auto to learn more about what vehicles should cost, and compare them to your max price cap.
If you can’t find any within your price range, start searching the Internet and used car dealers (very used if you have to).
This 1/10th rule only accounts for your annual income though. A better way to determine your car spending is your overall net worth, because that takes into account all your liabilities as well as your income. So, you get a better idea of how much you can really afford.
Buying A Vehicle Based On Your Net Worth
Your Net Worth is a number that’s calculated by subtracting all your liabilities from your assets. Unless you are house-heavy (a lot of people are), your net worth will be comprised mostly of savings that’s liquid.
Now, take 5% of this figure and go buy yourself a vehicle.
This means if your net worth is $100,000, you can afford a $5,000 vehicle. Does this mean a millionaire should be driving a $50,000 vehicle? Yes.
If that seems a little ridiculous, consider this: Even multi-millionaires have problems managing their finances. For example, did you know Willie Nelson went from being one of the most famous country singers to being flat broke?
It’s true. His millions were yanked away from him because he relied on bad financial advice and ended up owing a lot of money to creditors — including the IRS.
So, it really does pay to be frugal when it comes to buying a vehicle because your life can be turned upside down in a heartbeat.
This net worth rule works well for older people who are retired and living at home, for people who are out of a job, or who have a stay-at-home spouse.
How does this usually play out in reality? Good question. Let’s say you’re 40 now, and you build a $1 million savings by the time you’re 65. You’re living on $60,000 a year from social security, dividend income, and your pension. Now, the 10% rule (1/10th rule) says you should only buy a $6,000 car.
It seems like a small vehicle comparatively.
If that’s too spartan for you, keep in mind that there are ways to adjust this upwards and still be rational about your purchase. You could apply the percentages to both your income and your net worth or savings. So, for example, if you have a $1,000,000 net worth and a $100,000 income, you may decide that you apply both rules, appropriately.
That means applying 5% to the net worth and 10% to the income. This gives you $60,000 to spend on a vehicle. That’s enough to buy yourself something pretty amazing without feeling you’re going too far into the hole over a car.
Some Ideas To Increase The Amount You Can Afford
If you want to afford more vehicle, you have to earn more money, or save more. You could also make monthly payments easier on yourself by lowering your auto insurance costs, which will free up more money. Shop around for insurance.
Take up a second job, or drive for a ride sharing service. Track your net worth, reduce fees, and do pretty much anything you can to cut costs and increase your savings and net worth.
Laura Craig is currently on maternity leave from her job in the auto industry. To keep herself busy, and her mind active, she is writing articles based upon what she knows.