Buying a car is the second biggest buying decision after a home. While it’s okay to occasionally binge, over-stretching your car budget can cause financial angst and jeopardise long-term financial plans. Spend only what you can truly afford. How do you do that?

how much should you spend on your car

1. Follow thumb rules

There is a thumb rule of not spending more than half of your annual household salary on the car. An individual earning Rs 10 lakh a year should at best buy a car worth Rs 5 lakh. However, ensure it’s the on-road price of the car and not the show room price. On-road price is the final cost including registration charges, road taxes and insurance. It is 15%-20% higher than the show-room price. 

Planning to take a car loan? Ensure you follow another thumb rule of 20/4/10. 

Make a down payment of at least 20% of the car price. 

Take a loan for no more than four years. Keep your car payment to 10% of your salary, including EMIs and insurance expenses.

Longer the loan term, greater the interest you pay. At 11 %, the 20/4/10 rule indirectly limits your car budget to about 4 months of your salary. That’s lesser than if you had not taken a loan. 

Cars are depreciating assets. The moment you drive your car out of the showroom, its price falls by 20%. Over a period of five years, the value of your car depreciates to less than half (45%) of the buying price. 

2. Avoid negative compounding

Cars are depreciating assets. The moment you drive your car out of the showroom, its price falls by 20%. Over a period of five years, the value of your car depreciates to less than half (45%) of the buying price. 

Just because you are eligible for a larger loan doesn’t make it affordable. Stretching your car budget is tantamount to negative compounding. Take for instance, a car buyer making a choice between a Rs 6 lakh car and a Rs 10 lakh car. He takes a four-year loan at 11% p.a. There is an opportunity cost here. The extra Rs 4 lakh invested in equities could have yielded Rs 2.3 lakh in growth in about 4 years, at 12% p.a. Moreover, there is the interest payment of Rs 96,234 over the loan tenure which could have yielded Rs 55,700 in growth if invested in equities. Effectively, you lost an opportunity to earn Rs 2.9 lakh by buying a costlier car.

3. Old v/s new

Often, poor public transport system forces individuals to buy their own cars. It gives them the freedom to move whenever they want and not depend on capricious cabs or auto rickshaws. 

If budget is a constraint, consider buying a used car instead. It’s cheaper by 30%s-40% depending on the condition of the car and its age. However, ensure you don’t end up paying more for its maintenance. Avoid cars older than five years. 

If your friend does pass a snide remark on you buying a used car, do mention to him that one of the richest men in India used to purchase a used car for most of his life. 

4. No saving, no car

Last but not the least; ensure you are saving more than your car EMIs – at least 10% of your income in the form of savings. If not, consider delaying the purchase decision till your financial situation improves.

no saving no car

Takeaway

Spend only what is necessary and make sure it is not more than six months of your salary. Stretching your budget entails a significant opportunity cost. 

Frequently Asked Questions

How much should you spend on a car a year?

The answer depends on how much you earn per year and other liabilities you pay. Unlike the house, the car has value depreciation and a limited usage period. Hence, the spending should not go over 30% or 35% of the annual income on average. However, people who get less paid might need to reduce this percentage to be as low as 15%. While others who get well paid with fewer liabilities might be able to afford 50% of their annual income.

How much of your net worth should you spend on a car?

Most experts recommended not to spend on a car more than 10% of your net worth. However, many people especially those who get high annual net worth considered this as a very low percentage, and the average percentage should be as high as 35% of the net worth.

Is it better to lease or buy?

In general, it is better to buy a car than to lease one. Although the installment amount is higher than the leasing cost, it has a maturity date at which you will own the car with no further installment. Also buying a car means you are paying for an asset that can be a source of income if you decide to sell it in the long term.

How much is too much for a car payment?

The answer to this question is simply what you cannot afford to pay is considered too much. Even if you cannot afford to pay in full for the car and went for a bank installment program at no interest, it is still important to think of the other liabilities and the installment amount. This is to ensure it is affordable otherwise you will end up falling into debt.