New and used car sales are remaining strong in a sluggish economy, as millions of consumers find they can get financing for the vehicle of their choice. But behind those bullish car sales numbers is cause for concern, according to a personal finance webite.
“What really got us going was when we saw the average cost of a new car or truck last year was $30,000,” said Mike Sante, managing editor of Interest.com. “And that just seemed like an extraordinary amount of money.”
So much money that Sante and his staff wondered how consumers could afford it. They conducted a study and found that, for the most part, they can't.
They studied the top 25 cities and calculated the average income. It turns out that residents of only one city – Washington, DC – could afford to pay $30,000 for a car, based on a sound personal finance metric that we'll get to later. According to this formula the average consumer in Houston can only afford a $19,000 car. The average consumer in Philadelphia can only afford to pay $21,000.
You can buy it anyway
So, if nobody can afford to buy a $30,000 vehicle, how are they doing it? Simple, says Sante, they're being sold cars they can't really afford.
“What really defines affordability?” Sante asked. “Unfortunately, I think most people define that by how much the monthly payment is. A lot of people think, if the check doesn't bounce I must be able to afford it.”
But when they do that, they're inefficiently allocating their resources. They're taking a lot of money out of their pockets they could use to invest in themselves, or save up a reserve fund.
They're strapped, and they might not understand why. Chances are, it's because of the expensive vehicle in the driveway. This doesn't happen by accident.
“If you go into a car dealership, one of the first things the salesman will ask you is 'how much of a payment do you think you can afford?'” Sante said. “I think that if you ask a lot of people, they don't have a very good sense of what's affordable. For most people, the car dealer ends up defining it. We're trying to figure out a way to get people to think about cars in terms of what they can really afford.”
As part of their study, Sante and his staff interviewed a number of financial planners and adopted the 20-4-10 rule. When buying a car, you should put 20 percent down, finance it for no more than four years, and keep the principal, interest and insurance total for the year at no more than 10 percent of your annual gross income.
Using that formula, you may not be able to afford a $30,000 vehicle, even though the dealer is perfectly happy to sell you one. If this sounds familiar, it should. It's exactly how the housing bubble started.
Before going car shopping, consumers should sit down and figure out how much car they can afford, without focusing on the monthly payment. Interest.com has an auto loan calculator that can help you decide what you can afford by plugging in some key numbers.
You may discover you can't afford the car you really want. The good news is, there are plenty of new and late-model used cars that probably are in your price range.
For comparative purposes, the average price of a new car or light truck in 2012 was $30,550, according to TrueCar. That equates to a monthly payment of approximately $601. If your numbers are less than that, don't let the salesman sway you.
“The dealer wants it to be an emotional decision that wraps your self-esteem up in what you're driving,” Sante said. “We're trying to separate those things and say, this can't be an emotional decision. It needs to be a dollars and cents decision.”