Driving down car debt commitment

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As the weather heats up, so does action on car dealer lots and showroom floors. Many American consumers will be trying to reconcile their bank account balances with that delightful new-car smell, asking "how much car can I afford?"

Vehicle purchases are vitally important money decisions. Not only are autos expensive — the average price of new cars is more than $31,000, according to Kelley Blue Book — the buying decision could hamstring your cash flow for years into the future. Vehicle choice often involves not only how much you'll be shelling out in loan payments for an asset that is plummeting in value but how much you'll spend on gas, insurance and auto repairs.

Indeed, median income households in only one major U.S. city, Washington, D.C., can afford payments on the average price of a new car today, about $600 per month, according to a study by Interest.com.  

"What this research indicates, more than anything, is that a lot of Americans are spending too much money on their cars," Mike Sante, managing editor of Interest.com, said in a statement. "Car costs are one of the most controllable parts of a household's budget."

So, before you dive in and research which next vehicle you should buy, answer the most important question first, "how much car can I afford?"

The answer will vary widely depending not just on your income but how much debt you already have and what your expenses are. Still, having a few rules of thumb can help introduce a dose of reality into your new-car dreams.

Here are a few rules of thumb.

Borrow for four years or less. As vehicles become more expensive, loan terms have lengthened. Loans can go to six or even eight years — that's 96 months. Nearly one-third of loans are for 72 months or longer, according to a recent J.D. Power and Associates report.

While some consumers are buying larger and more expensive vehicle because they need them, others have a case of the "wants."

"It's not based solely on needs," said Alec Gutierrez, senior market analyst for Kelley Blue Book. "People are jumping back into the marketplace and better equipping their vehicles because they can keep their payments low based on these longer terms."

A general rule of thumb is take an auto loan for no longer than four years.

Money guru Clark Howard, who doles advice on radio and television, has long advocated not taking out a loan longer than 42 months, or 3.5 years. "If your payment is too much at 42 months, that means you're buying too much car," he has said.

So, instead of financing for a longer period to reduce monthly payments, get a smaller payment by purchasing a less-expensive car. That might mean buying your favored vehicle as a two- or three-year-old used car instead of new.

Keep payments to 20 percent of take-home pay. A focus on car payments is dangerous because simply lengthening the financing term lowers the monthly payments but makes the vehicle more expensive.

To determine how much car debt you can absorb, ideally you would do in-depth analysis of your finances. But as a rule of thumb, keep the total of all vehicle payments to less than 20 percent of take-home pay, not gross pay. 

The National Foundation for Credit Counseling advice is more strict — suggesting that no more than 20 percent of take-home pay should go to all non-housing debt, including credit card debt. The idea is that the 20 percent for debt plus the 30 percent that often goes toward housing leaves you half your take-home pay to eat, pay utilities, put gas in the car and pay for the rest of life's necessities, said NFCC spokeswoman Gail Cunningham. 

"Allocating too much to your two largest payments, house and car, takes its toll on a budget," Cunningham said.

20/4/10 rule. This combines several rules, referring to a 20 percent down payment, a loan term of four years or less and payments plus auto insurance not to exceed 10 percent of gross income. This rule is expressed differently than the 20 percent of take-home pay above by referring to gross income and including car payments plus auto insurance.

Don't buy a new car. Depreciation is the issue here. A new car can depreciate 30 percent in the first year. That's losing $9,000 in value on a $30,000 car during the first year. Is $9,000 a big deal in your life?

That's why financial author and talk-radio host Dave Ramsey often says, "You can't afford a new car unless you are a millionaire" and, thus, able to absorb such a financial hit.

If you instead buy a one- to three-year-old vehicle, you let somebody else "pay" that depreciation.

If you're uncomfortable buying used, perhaps it would ease your mind to buy a used vehicle that is certified by the manufacturer.

"I'm a big fan of certified used vehicles, especially leased cars that have just come back to the lot," said Farnoosh Torabi, personal finance expert and host of Financially Fit on Yahoo.

Don't lease. If you leased a car because you couldn't afford payments, your automobile tastes might be outpacing your wallet. Generally, financial experts frown on serial leasing for most people because they are continually paying for only the most expensive part of a car's life, the first few years.

Vehicle values should be less than half your income. The total current value of all your cars — plus boats, motorcycles and snowmobiles, etc. — should be less than half of your gross annual household income, according to another Ramsey rule of thumb. That's regardless of whether you own the vehicle or continue to make payments.  Find the current value of vehicles at such Web sites as Kelley Blue Book (kbb.com). 

The idea is you need to limit the amount of money you have tied up in depreciating assets.

Pay cash. Paying cash for a new vehicle seems absurd in households that don't have an extra 30 grand stashed away. But it's not as crazy as it sounds. First, recall that not everybody buys new cars. So, maybe the purchase price is closer to $15,000. And most people have some value left in their existing vehicle that they can sell or trade in. If that's worth $5,000, the balance you need to come up with is $10,000.

One long-term trick is to continue making car payments to yourself — perhaps in a separate bank account — long after you stop sending in auto payments to your lender. If your payment was $400 per month, it would take only about two years to build up $10,000 to pay cash for your next vehicle.

Drive until the wheels fall off. Not to be taken literally, this hints at the wisdom of keeping a vehicle a long time, say, more than 10 years. Indeed, even the depreciation hit you asborb in buying a new car softens if you keep a vehicle a long time. The average age of a car on the road today is 11 years, Gutierrez said.

Remember that car repairs are typically cheaper than car payments, Cunningham says. Another rule of thumb: If an auto repair costs less than half of the trade-in value, repair it. Otherwise, considering selling your vehicle and buying another.

Perhaps the best advice is realizing the importance of car affordability in your financial life.

"Shop with your head, not your heart," Cunningham said. "Since car loans last longer than some marriages, you'll want to approach this love affair in responsible manner."

gkarp@tribune.com

Twitter: @spendingsmart

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