Here’s how to calculate how much you can afford to spend on your next car

First car. New-to-you car. Nice car. Functional-only car. Need-one-in-a-rush car. Here are two rules to follow to save money on your next car purchase no matter how you’ve arrived at the decision to get one ... assuming you need one, because you can save a heck of a lot of money by not having one at all.

If you’re paying for the car in instalments (financing or leasing)

This isn’t a debate between financing or leasing. Both types of financing arrangements can work depending on your personal circumstances. What’s important in protecting your personal finances though is ensuring you can actually afford the full costs of this car.

Beyond the car payment, there are insurance and gas costs that are fairly predictable. There are maintenance, parking, registration and membership costs that sit on top of these. Sometimes, dealerships also allow financing of the warranty itself. When you add all of the costs together on either a monthly or annual basis, you don’t want this total value to consume more than 10 per cent of your take-home pay. If you have a spouse who is working, and two cars, the same applies, but to your household income.

Let’s run a scenario: Your pay cheques total $5,650 each month (that’s after taxes). Ten per cent of your monthly take-home pay is therefore $565. That’s the all-in car budget. Break this down; $325 toward a modest car payment, $75 for gas, $115 for insurance and $50 for parking and maintenance (if you don’t pay for parking one month, you’d save that money for future repair bills).

This isn’t much to spend on a car, but the logic is this: if you spend much more than this, especially if you live in an expensive city, there won’t be enough money left over for housing costs (many Canadians earmark 40 per cent of their income for this), food and family (another 25 per cent easily goes here with groceries, meals out and kid expenses being so pricey), debt servicing (10 per cent minimum toward consumer debt), saving (five per cent toward a rainy-day fund is highly recommended), investing (five per cent toward TFSAs and RRSPs) and discretionary spending on things that make your life better (five per cent). 

Tally those percentages up and what you have is 90 per cent of your income going toward everything but this car. That’s why you don’t want to nudge much past this 10 per cent budget for the car and its associated costs. 

Of course if you don’t have debt, if you get a car allowance through work (which is often a taxable benefit, btw) and if your housing costs are significantly less, that might provide a bit of additional budget for your vehicle, but I always like to ask, “Would you rather spend that extra money on a car that depreciates in value or toward building your net worth (saving and investing that money and/or paying off debt)?” This rule ensures that transportation stays a modest share of both your budget today and your lifetime wealth, preventing a depreciating asset from crowding out long-term savings.

If you have savings and plan to pay for the car outright

This scenario is for folks who have savings and don’t need to borrow to buy their car. Take your gross income, multiply it by 20 per cent (0.20), and that’s your budget for buying a car outright.

Let’s run a scenario: Say your household earns $100,000 per year; that means the budget for your vehicle purchase is 20 per cent of that income, so $20,000. That puts you solidly in the used-car market, but allows for you to own something of good quality, without any payments. 

The 20 per cent rule exists because a car is a rapidly depreciating asset that must be replaced multiple times over a lifetime. Spending more than about one-fifth of annual income converts too much future investment capital into consumption. Since every extra dollar spent on a car today forgoes roughly five to six dollars of retirement wealth due to compounding, this rule keeps your car purchases from permanently eroding long-term net worth.

Of course, if you’ve got some kind of cash windfall coming your way, or have a very unique need for a higher-priced vehicle (like a truck that will be used for business purposes and that you can track mileage for tax purposes), you may want to adjust your budget upwards slightly.

These two rules end up very close to what financial planners call a consumption smoothing optimum, meaning the rules aren’t just practical, they’re near the mathematically optimal lifetime spending strategy for Canadians who want to achieve financial security over time. Spending more on either payments of buying a car outright compromises your ability to save.

Food for thought, right? If you’re in the market this spring for a car, how would you recalibrate your budget using these rules?

This article was originally published in The Star. Lesley-Anne Scorgie is a Toronto-based personal finance columnist and a freelance contributing columnist for the Star.