KILDARE'S MAKING CENTS: How much should my car payment be?

I READ an article years ago and if I can remember correctly, it suggested that Tuesday was the day of the week when most used or new cars were bought and the first or second Tuesday of February was the most popular day of the year to buy a car.

I’m not sure if this still stands or not but it doesn’t really matter because there’s never a bad time to give you financial advice when it comes to buying a car and what you should be considering from a financial perspective before you do.

And aside from buying a house, for most buying a car is the second most expensive purchase they’ll ever make, so they want to make sure they get it right.

And getting it right is making sure that if you’re borrowing money to fund the purchase, you don’t end up paying too much every month.

So, in this article I’m going to help you figure out how much you should be paying each month for any car you purchase.

And there are some rules of thumb that are often bandied about in this regard but the one I like most is called the 1/10th rule and that’s where you don’t spend any more than 10% of your gross annual income on car loan repayments.

So, if for example you earn €40,000, your annual car monthly repayments shouldn’t be greater than €4,000. If you earn €75,000, they shouldn’t be more than €7,500 and so on.

I’ve heard some financial advisers suggest your monthly costs can be as high as 15% of your net monthly income, but personally I think that’s too high and I say that because I see first-hand the impact high car repayments have on other areas of people’s finances i.e. they can’t contribute as much as they should be to their pension or savings accounts, or they struggle with monthly cash flow or they’d struggle to keep up with repayments if their income was to reduce etc.

The sweet spot with having car repayments or any other loan repayments for that matter is still being able to put somewhere between 10% and 20% of your monthly income into savings and retirement accounts, being able to cover all of your essential expenses each month and after all of that still have some money left over at the end of the month that’s yours to spend on whatever you want to.

A big ask I know.

But you don’t want to purchase a car without first knowing how that monthly cost will impact other areas of your finances. Will it mean you have to reduce the amount you save or will it put you under pressure with cash flow each month?

It might or it might show that you could in fact borrow more if you wanted to without impacting any other areas of your finances, but I think plugging whatever that future monthly cost might be into what your present income and outgoings are and seeing what your finances will look like then is an exercise worth doing.

Because it could confirm as I said that you could handle monthly repayments that are far greater than the 10% number that I’m suggesting or it could be that you need to dial it back to say 5% of your monthly income, but just look before you commit to anything.

And of course, a monthly loan repayment isn’t the only thing you’ve got to be mindful of. There are other monthly outgoings you have to factor into the running cost of a car i.e. tax, insurance, maintenance, parking, tolls, fuel etc.

So you need to be cognisant of what they are as well and how much they’ll cost, which is why I think the 10% rule is a good one, because it keeps this particular monthly outlay in check with your monthly income.

And I’m sure some people reading this will think that if they followed this 10% rule, they’d never be able to buy a decent car given how expensive new and used cars are today. And I guess that’s where the type of finance product you take out can help.
And with that in mind, it shouldn’t come as any surprise that about 50% of people who are arranging finance to buy a car are doing so with the help of a personal contract purchase, more commonly known as PCP.

And PCPs are specifically designed to make it more affordable to purchase a new car. They are structured so you pay a deposit and monthly instalments over a fixed term. And the payments are typically lower than say a term loan because all you’re paying for with a PCP is the vehicle’s depreciation over a three or four year term rather than its total value.

And as a result you never really own the car outright unless you make one final bullet repayment at the end of the agreement. Or you could also hand the keys back or trade the car in for another using its guaranteed future value feature.

When you look at the numbers of someone earning for example €50,000 and they follow the 10% rule, they would have monthly repayments of c. €416 over four years which would equate to a loan of about €21,000.

How much savings they’ll use and/or what the trade in value of their existing car is, will influence how much they can spend on a car.

That same person, earning the same amount could, using a PCP arrangement, buy a car costing circa €55,000 and have 36 monthly repayments of about €369 which is lower than my recommended 10% number.

But here’s the kicker, to own the car outright they’d have one more final payment of circa €26,000 otherwise they’d have to give the car back or arrange another PCP type contract on another car.

So, I guess whether you want to own the car outright or just rent it for a period will influence the monthly cost and the price you spend on a car.

You can certainly drive a more expensive car using PCP finance than you could if you borrowed money by way of a term loan but regardless of which you choose I think it’s important to keep those repayments under 10% of your gross monthly income. And having said that you’ve also got to familiarise yourself with and understand the type of loan you’re taking on to make sure it’s the right one for you.

I’ll leave you with this.

I listened to a podcast before Christmas where the topic was, what are the top 10 most common financial mistakes people make. And unsurprisingly to me, there I think at number seven was: replacing your car too often and buying a new car.
And they weren’t wrong.

Because the real savings with the ownership of a car, is when you have no more monthly repayments, which means that once the loan is repaid, you should continue making those repayments into your savings account rather than into a bank account.
If you do, they can be used towards your next purchase and can help you buy a bigger and more expensive car than before without having to take on a bigger loan.

So, the lesson we should take from this is, don’t let the end of a car loan be the trigger to take out a new one.

And secondly just because you can afford the payment doesn’t mean you should buy a new car. Cars are depreciating assets, which means they drop in value as they age. A new car could lose circa 20% to 30% of its value in the first couple of years of ownership.

Before I finish, I want to give you some more things to consider, which I’m hoping that along with the 10% rule I’ve been telling you about will hopefully prevent you in the future from driving a car you can’t afford, and they are:

• Take care of the car you have, so you don’t have to change it any sooner than needs be.

• Don’t prioritise how a car looks over anything else. What should be at the top of your list is a car that is reliable, has a good reputation, won’t break down frequently, and one you’ll still be able to drive in 10 years, if you wanted to.

• Look over your income and outgoings to see how much you're spending and saving each month. This will give you an idea of how much you can afford to spend on monthly repayments. And whatever you discover, don’t break your budget.

Sometimes you’ve got to cut your cloth to suit your measure which means setting a realistic number and not going over it if you can help it at all.

You don’t want to make too many sacrifices or increase your stress levels needlessly because your car loan repayment is too much.Liam Croke is MD of Harmonics Financial Ltd, based in Plassey. He can be contacted at liam@harmonics.ie or www.harmon5ics.ie