Rising car payments make affordability benchmarks ‘impossible’

Dartmouth, Nova Scotia, Canada - June 12, 2011: New Toyota cars line up at the auto dealership.  Founded in 1937, Toyota is one of the largest automobile manufacturers in the world.  They make a wide variety of cars including the ever-popular Corolla and Camry.

Some personal finance experts say that the basic historical rules for determining the affordability of a car payment don’t match the fact that car prices and borrowing rates are soaring.

With car prices and payments rising, it’s becoming increasingly difficult to rely on many of the traditional rules used to determine how much you can afford in car payments.

“We have a lot of people who rely on ground rules and it’s impossible to use them,” said Sejal Patel, founder and CEO of personal finance company Saij Elle. Yahoo Finance Canada In a telephone interview.

“It’s dangerous, in my opinion, to use it because you have to put it all in context.”

One long-standing rule of thumb that has permeated the world of personal finance is that your total car expenses, including payment, gas, and insurance, should equal 10 to 15 percent of your gross paycheck.

Another common rule of thumb for affordability when buying a car is the 4/10/20 method. A down payment of at least 20 percent is suggested, the car loan should not exceed four years, and the monthly payment should be no more than 10 percent of your outstanding salary.

But Patel says the reality of purchase prices and ownership costs often outpace those bases, so a broader look at an individual’s financial situation is needed to determine affordability.

“I wouldn’t advise someone about a car without first understanding their entire income, account picture and all other goals and necessities,” she said.

“My point is rule of thumb – 9/10 doesn’t work. Because every circumstance is different and when you have limited resources competing with many priorities, you have to plan and then prioritize.”

Personal finance comparison site Finder.com says Canadians typically spend between $400 and $800 on the average car payment. For new cars in particular, the average monthly payment is closer to the higher end of the range. Factor in the costs of gas, insurance, maintenance/repair, and that number balloons, so it easily exceeds traditional vehicle affordability guidelines.

Patel gives the example of buying a car worth $45,000 plus taxes with a 20 percent down payment. A four-year loan at three percent interest would cost $940 per month. Factoring in $500 for insurance, gas, and maintenance, the monthly cost for that car would be $1,440.

For an individual with an annual salary of $72,000, or about $4,273 per month after tax, a car would eat up to 34 percent of his monthly income.

“These are real numbers. And then you have rent, you have food, and you have to save for retirement. So how do you meet those expenses?” Patel said.

It says it will advise customers to calculate their monthly net income and fixed expenses to gauge how much money they have left to contribute to the purchase of a car.

How to save on car payments

Patel says buyers can consider saving a larger car down payment to lower the monthly cost, or extending the car loan beyond the four-year guideline, which is “not the worst thing in the world,” she says, especially if a car is a necessity.

When an agent offers promotional financing, such as zero percent financing or no payments for a number of months, Patel cautions buyers to read the fine print.

Reading the fine print of merchant financing options can reveal unnecessary additional features, additional fees, and provide a better understanding of the interest rate being charged.

“Merchants get creative when trying to attract new customers and one popular method is to promote 0% financing. In general, interest-free loans aren’t a good idea if you’re constantly juggling bills, are often late with payments or can’t afford to pay,” said Romana King, senior editor. Finder Financials, via email: “Finding Extra Money to Pay Off High-Interest Debt.”

She adds that for those who consistently pay bills on time and can plan to pay off loans quickly, promotion financing may be a decent option.

“Just make sure you run the numbers and are confident you can pay back the loan, or a significant portion of the loan, within the promotional period to avoid exorbitant interest charges (and keep monthly payments lower),” she said.

King also suggests sorting out financing before you pull into a parking lot, rather than trying to negotiate with the dealer about the car’s price and financing terms.

Buyers can also look for car models that may have fallen out of favor with consumers.

“While inventory has been tight over the past few years, there are always brands and models that don’t get the traction. If you’re not stuck with one or two makes/models, you can snap up those unwanted models for a cheaper price tag.”

Michelle Zadikian is a senior correspondent for Yahoo Finance Canada. Follow her on Twitter @employee.

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