If you're in the research phase of the car buying process, you probably made a quick discovery - new cars are expensive. The median new car price is growing every year, topping off around $36,000 in 2019. Car shoppers are foregoing affordable vehicles and splurging on cars they can't afford which results in financial struggles and even repossession. If you haven't heard of the 10% rule when it comes to car buying, you should know it may be the most effective at keeping you out of trouble. Learn what the 10% rule for car shopping is, how to apply it to your car purchase, and what to do if you've broken this rule already.
What is the 10% Rule?
One reason we like the 10% rule from Sam Dogen of Financial Samurai is that it doesn't require you to whip out a calculator for any complex math. The formula is simple - don't spend more than 10% of your gross annual income on your car purchase. So if you make $50,000 per year in gross income, don't spend more than $5,000 on a car purchase. Yes, it sounds extreme, but before you close this article and rush out to buy that brand new $45,000 pickup truck in protest, hear us out.
Why Follow the 10% Rule?
The first reason to follow the 10% rule is that the sticker price listed on the car you're looking at is not the all-in cost to purchase and maintain the car. Once you figure in the hidden costs that come with a car purchase along with additional expenses such as interest, insurance, and maintenance, you're looking at thousands of dollars more than you anticipated.
Another reason to consider obeying the 10% rule is that you can avoid the stress caused by a monthly car payment that is too high. According to a study by AAA, the average yearly cost of a new vehicle is $9,289 which breaks down to $773.50 per month. To make the monthly car payments work, shoppers are stretching out their car loans well beyond the 5-year mark. Although this reduces the monthly payments, it also causes the buyer to overpay in interest and put themselves at risk for late payments, going underwater on the loan, and even vehicle repossession. By choosing a car that costs 10% of your gross income, you can be confident that you're not stretching yourself too thin.
How to Apply the 10% Rule to Your Car Purchase
If you choose to protect your financial health by following the 10% car buying rule, your best bet will be to look for a reliable used vehicle that will serve its purpose of getting you from point A to point B. So how do you know which vehicles can you afford? Financial Samurai makes it easy and gives us a breakdown of sample cars that you can buy using the 10% rule based on your household income.
We know the guidelines above look a bit extreme, (you can only buy a new Honda Accord if you make over $200k per year?) but they can also serve as a reality check. That vehicle you thought was in your budget may actually put a strain on your finances when all is said, done, and signed. If your household income is less than $100,000, the 10% rule nudges you to go with a used vehicle. Buying a car that is 3-5 years old lets you avoid paying the price of depreciation and still gives you a reliable vehicle that will serve you for years to come.
What if You Already Broke the 10% Rule?
If you're thinking, "it's too late for me, I've already broken the 10% rule," you're not alone. Most car shoppers spend much more than this recommended amount on their vehicles and are dealing with the consequences. When you've overspent on your vehicle, there are some remedies that can get you back on the right track. The easiest way to course-correct for overspending is by driving the vehicle until it costs 10% of your income. Some car owners trade in their vehicles before they are paid off and roll up their current car loan into a new loan, starting a cycle of debt.
Another solution, as unpleasant as it may feel, is to sell the vehicle. Since new cars depreciate as much as 20% as soon as they are driven off the lot, you'll likely take a hit when you sell the car. Taking this step will be hard, but it is better than the alternative of falling behind on your car payments and watching helplessly as your vehicle is repossessed. The 10% rule will be considered drastic by most folks, but getting your financial health on the right track sometimes requires drastic measures. Whether you're about to buy a car or have recently purchased one and are struggling with the payments, the 10% rule can serve as a caution sign to avoid or remedy a dangerous situation.