Rising car payments make standard affordability rules “impossible”

Dartmouth, Nova Scotia, Canada - June 12, 2011: New Toyota Vehicles in a Row at Car Dealership.  Founded in 1937, Toyota is one of the largest automobile manufacturers in the world.  They manufacturer a variety of automobiles including the continually popular Corolla and Camry.

Some experts in personal finance say that the historical rules used to calculate car payment affordability have not been updated to reflect current car prices and rising borrowing rates.

It is becoming increasingly difficult to rely upon the old rules of thumb to figure out how much you can afford for auto payments as car prices rise.

Saijal Patel is the founder and chief executive at Saij Elle. He stated, “We have so much people relying in rules of thumb, it’s impossible for them to use.” Yahoo Finance Canada In a phone interview.

“It is dangerous to use them, in my opinion, because you must put it all into context.”

The personal finance world has a long-standing rule that vehicle expenses should not exceed 10% to 15% of your gross salary.

The 20/4/10 rule is another common affordability rule for buying a car. It requires a downpayment of no less than 20%, a maximum term of four years for the car loan, and a monthly payment of not more than 10% of your weekly take-home income.

Patel claims that the reality of ownership and purchase prices often exceed these rules. Therefore, it is important to look at a person’s financial situation in order to determine affordability.

She said, “I would not advise anyone to buy a car without first understanding their whole income, expenditure picture, and all other goals and needs.”

“My point is rule of thumbs – 9/10 don’t work. You must prioritize and plan for every situation.

According to Finder.com personal finance comparison website, Canadians spend an average of $400-$800 per month on their car payments. New vehicles have a higher average monthly payment, which is why it’s closer to the upper end of this range. When you add in maintenance/repair and insurance costs, the cost of gas and insurance can easily exceed traditional car affordability guidelines.

Patel gives the example of a $45,000 vehicle purchase plus tax with a 20% downpayment. A $45,000 loan at 3 percent interest for four years would cost $940 per monthly. The monthly cost of this vehicle would be $1,440 if you add $500 for gas and insurance.

A person earning $72,000 per year, or $4,273 per monthly after taxes, would pay 34 percent for the vehicle.

These are real numbers. You have rent, food and retirement savings. How can you make ends meet? Patel explained.

She advises clients to add up their monthly net income to determine how much money they have left to buy a car.

How to Save on Car Payments

Patel suggests that purchasers consider putting down a higher downpayment to lower monthly costs or stretching the car loan beyond its four-year limit. This is especially true if the car is a necessity.

Patel cautions buyers against buying promotional financing from dealerships, which may include zero percent financing or no payments over a period of time.

You can find out more about dealer financing options by reading the fine print. This will help you understand the interest rate and avoid unnecessary fees.

“Dealer’s are finding creative ways to attract customers. A popular strategy is the 0% financing promotion. Romana King, senior finance editor for Finder, said via e-mail that interest-free loans don’t make sense if you are constantly juggling bills and can’t afford to pay higher-interest debt.

She adds that a financing promotion could be a good option for people who are punctual in paying their bills and have the ability to quickly repay loans.

She said, “Just make sure you have run the numbers and are confident that you can repay the loan or a substantial portion of it within the promotional period to avoid high interest fees (and lower monthly payments)”.

King suggests that financing be arranged before you go to the car lot. This is better than trying to negotiate terms with the dealer about both the car’s price and financing terms.

You can also search for models that have fallen out of favor with buyers.

“Inventory was not as tight in the last few years but there are always models and makes that go out of fashion.” These out-of-favour models can be purchased at a lower price if you don’t want to hold onto just one or two models.

Michelle Zadikian works as a senior reporter for Yahoo Finance Canada. Follow her Twitter @m_zadikian.

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