Jan Stromme/The Image Bank/Getty Images Plus
Jan Stromme/The Image Bank/Getty Images Plus
New cars these days have better safety features and more tech gizmos than models from a decade ago. And let's face it: Trading in a beat-up clunker with grimy seats is an enticing idea.
But many Americans make big mistakes buying cars. Take new car purchases with a trade-in. A third of buyers roll over an average of $5,000 in debt from their last car into their new loan. They're paying for a car they don't drive anymore. Ouch! That is not a winning personal finance strategy.
But don't worry — NPR's Life Kit is here to help. Here's how to buy a car without getting over your head in debt or paying more than you have to.
1. Get preapproved for a loan before you set foot in a dealer's lot.
"The single best advice I can give to people is to get preapproved for a car loan from your bank, a credit union or an online lender," says Philip Reed. He's the autos editor at the personal finance site NerdWallet. He also worked undercover at an auto dealership to learn the secrets of the business when he worked for the car-buying site Edmunds.com. So Reed is going to pull back the curtain on the car-buying game.
For one thing, he says, getting a loan from a lender outside the car dealership prompts buyers to think about a crucial question. "How much car can I afford? You want to do that before a salesperson has you falling in love with the limited model with the sunroof and leather seats. "
Reed says getting preapproved also reveals any problems with your credit. So before you start car shopping, you might want to build up your credit score or get erroneous information off your credit report.
And shop around for the best rate. "People are being charged more for interest rates than they should be based upon their creditworthiness," says John Van Alst, a lawyer with the National Consumer Law Center.
Van Alst says many people don't realize it, but the dealership is allowed to jack up the rate it offers you above what you actually qualify for. So with your credit score, "you might qualify for an interest rate of 6%," says Van Alst. But, he says, the dealership might not tell you that and offer you a 9% rate. If you take that bad deal, you could pay thousands of dollars more in interest. Van Alst says the dealership and its finance company, "they'll split that extra money."
So Reed says having that preapproval can be a valuable card to have in your hand in the car-buying game. It can help you negotiate a better rate. "The preapproval will act as a bargaining chip," he says. "If you're preapproved at 4.5%, the dealer says, 'Hey, you know, I can get you 3.5. Would you be interested?' And it's a good idea to take it, but make sure all of the terms, meaning the down payment and the length of the loan, remain the same."
One word of caution about lenders: Van Alst says there are plenty of shady lending outfits operating online. Reed says it's a good idea to go with a mainstream bank, credit union or other lender whose name you recognize.
2. Keep it simple at the dealership.
If you're buying a car at a dealership, focus on one thing at a time. And don't tell the salespeople too much. Remember — this is a kind of game. And if you're playing cards, you don't hold them up and say, "Hey, everybody, look — I have a pair of queens," right?
So at the dealership, Reed and Van Alst both say, the first step is to start with the price of the vehicle you are buying. The salesperson at the dealership will often want to know if you're planning to trade in another car and whether you're also looking to get a loan through the dealership. Reed says don't answer those questions! That makes the game too complicated, and you're playing against pros. If you negotiate a really good purchase price on the car, they might jack up the interest rate to make extra money on you that way or lowball you on your trade-in. They can juggle all those factors in their head at once. You don't want to. Keep it simple. One thing at a time.
Once you settle on a price, then you can talk about a trade-in if you have one. But Reed and Van Alst say to do your homework there too. A little research online can tell you what your trade is worth in ballpark terms. Reed suggests looking at the free pricing guides at Edmunds.com, Kelley Blue Book and NADA. On Autotrader, you can also see what people in your area are asking for your car model. And he says, "You can get an actual offer from Carvana.com and also by taking the car to a CarMax, where they will write you a check on the spot."
So he and Van Alst say don't be afraid to walk away or buy the car at a good price without the trade-in if you feel the dealership is lowballing you on your old car. You have plenty of other good options these days.
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Will Sanders/Stone/Getty Images Plus
Will Sanders/Stone/Getty Images Plus
3. Don't buy any add-ons at the dealership.
If you've bought a car, you know how this works. You've been at the dealership for hours, you're tired, you've settled on a price, you've haggled over the trade-in — then you get handed off to the finance manager.
"You're led to this back office. They'll often refer to it as the box," says Van Alst. This is where the dealership will try to sell you extended warranties, tire protection plans, paint protection plans, something called gap insurance. Dealerships make a lot of money on this stuff. And Van Alst says it's often very overpriced and most people have no idea how to figure out a fair price.
"Is this add-on, you know, being marked up 300%? You don't really know any of that," Van Alst says. So he and Reed say a good strategy, especially with a new car, is to just say no — to everything. He says especially with longer-term loans, there's more wiggle room for dealers to try to sell you the extras. The finance person might try to tell you, "It's only a little more money per month." But that money adds up.
"Concerning the extended factory warranty, you can always buy it later," says Reed. "So if you're buying a new car, you can buy it in three years from now, just before it goes out of warranty." At that point, if you want the extended warranty, he says, you should call several dealerships and ask for the best price each can offer. That way, he says, you're not rolling the cost into your car loan and paying interest on a service you wouldn't even use for three years because you're still covered by the new car's warranty.
Gap insurance promises to cover any gap between the purchase price of replacing your almost-new car with a brand-new car if your regular insurance doesn't pay for full replacement if your car gets totaled. Van Alst says gap insurance is often overpriced and is fundamentally problematic. If you still want the product, it's best to obtain it through your regular insurance company, not the dealer.
4. Beware longer-term six- or seven-year car loans.
A third of new car loans are now longer than six years. And that's "a really dangerous trend," says Reed. We have a whole story about why that's the case. But in short, a seven-year loan will mean lower monthly payments than a five-year loan. But it will also mean paying a lot more money in interest.
Reed says seven-year loans often have higher interest rates than five-year loans. And like most loans, the interest is front-loaded — you're paying more interest compared with principal in the first years. "Most people don't even realize this, and they don't know why it's dangerous," says Reed.
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Reed says that if you want to sell your car — you decide you can't afford it, or maybe you have another kid and need a minivan instead — with a seven-year loan you are much more likely to be stuck still owing more than the car is worth. So he says, "It puts you in a very vulnerable financial situation."
A better way to go, Reed says, is a five-year loan for a new car and "with a used car you should really finance it for only three years, which is 36 months." One reason that makes sense, he says, is that if your used car breaks down and isn't worth fixing — say the transmission totally goes — you're more likely to have paid off the loan by that time.
Reed says a five-year loan make sense for new cars because "that's been the traditional way — it's kind of a sweet spot. The payments aren't too high. You know the car will still be in good condition. There will still be value in the car at the end of the five years."
Also, Van Alst and Reed say to make sure dealers don't slip in extras or change the loan terms without you realizing it. Read carefully what you're signing.
Reed says a colleague at NerdWallet actually bought a minivan recently and "when she got home, she looked at the contract." She had asked for a five-year loan but said the dealership instead stuck her with a seven-year loan. "And they included a factory warranty which she didn't request and she didn't want." Reed says she was able to cancel the entire contract, remove the extended warranty and get a rebate on it.
"But the point of it is," he says, "I mean, here's somebody who is very financially savvy, and yet they were able to do this to her. And it's not an uncommon scenario for people to think that they've got a good deal, but then when they go home and look at the contract, they find out what's been done to them."
5. Don't buy too much car. And consider a used car to save a lot of money!
"The golden rule is that all of your car expenses should really be no more than 20% of your take-home pay," says Reed. And he says that that's total car expenses, including insurance, gas and repairs. "So the car payment itself should be between 10 and 15%."
And if a new car with a five-year loan doesn't fit into your budget, you might decide you don't really need a brand-new car.
"We're actually living in a golden age of used cars," says Reed. "I mean, the reliability of used cars is remarkable these days." Reed says there is an endless river of cars coming off three-year leases that are in very good shape. And even cars that are older than that, he says, are definitely worth considering. "You know, people are buying good used cars at a hundred-thousand miles and driving them for another hundred-thousand miles," says Reed. "So I'm a big fan of buying a used car as a way to save money."
He acknowledges that which car you buy matters and that it's a good idea to read reviews and ratings about which brands and models are more or less likely to run into costly repair problems down the road. He says some European cars are famously expensive to maintain.
NPR has a personal finance Facebook group called Your Money and Your Life. And we asked group members about car buying. Many said they were shocked by how much money some other people in the group said they were spending on cars. Patricia and Dean Raeker from Minneapolis wrote, "40 years of owning vehicles and our total transportation purchases don't even add up to the cost of one of the financed ones these folks are talking about."
Dean is a freelance AV technician, and Patricia is a flight attendant. They say, "our nicest, newest purchase was a 2004 Honda Accord for $2400, bought last year, that with regular maintenance could likely last another 100,000+ miles." And they say they "can't understand those who insist on driving their retirement funds away."
Even if you buy a slightly newer used car than the Raekers', the couple raises a great point. What else could you be spending that car payment money on? And if you can cut in half what you might otherwise spend, that's a lot of extra money for your retirement account, your kids' college fund or whatever else you'd rather be doing with that money.
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Article QuickTakes:
This rule suggests you can afford a car if you can meet the following three requirements:
In theory, this rule can help you in multiple ways. First, it makes sure you can afford a down payment on the car. This is important because new cars begin to depreciate when you drive them off the lot. Without a decent down payment, you may immediately end up upside down on your car loan.
A four-year car loan can help you limit the interest you pay because you'd pay off the loan relatively quickly. Finally, keeping your total transportation costs to less than 10% of your monthly income can help ensure a car doesn't dominate your budget and leaves room for other expenses.
Remember this is only a guideline that can inform your decision. It's impossible to make it fit every person's situation. You may decide to spend more money on a car because it's something you truly value or because you must have a reliable vehicle to keep a job. Others may decide to spend less on a car because they'd rather allocate their money elsewhere.
Using this rule in practice requires some thought but isn't difficult once you understand the process.
To start, you need to know the purchase price of a vehicle. This allows you to calculate how much a 20% down payment would be. Next, you can figure out how much you'd need to finance and get an estimated interest rate. Use this information to come up with the monthly loan payment, including interest costs.
Then, calculate the total transportation costs of a vehicle for a month as a percentage of your income. This is a bit trickier because it includes costs such as insurance, fuel, maintenance, and more. You can use a total cost of ownership calculator to estimate some of these expenses. You don't need to include any depreciation costs, but you do need to include the car loan payment.
Finally, divide the total cost of the vehicle by your monthly income. The 20/4/10 rule doesn't state if this should be your net income (after taxes and deductions) or your gross income (before taxes and deductions). You can use your best judgment or what fits your needs best.
Here's a hypothetical example: A person decides they want a $30,000 sedan. They calculate a 20% down payment would be $6,000. That leaves a balance of $24,000 to finance with a four-year loan at a 4.37% interest rate. This results in a monthly payment of about $546.
Next, they calculate other transportation costs. In this example, they may estimate monthly costs as follows:
Based on this estimated information, the total cost of ownership per month would average out to $803 for this vehicle. According to the 20/4/10 rule, the individual's monthly income would need to be $8,030 or higher to afford this payment.
It's important to note that this rule is far from perfect. Unfortunately, it's a longstanding rule that fails to consider the lack of significant wage growth compared to high inflation in the new car market. The U.S. household median income for 2010 was $49,276, which increased to $67,521 in 2020. This represents an increase of 37%. At the same time, the average price of a new car rose from $24,296 in 2010 to $40,107 at the end of 2020. That's an increase of almost 61%.
Rules like this don't typically account for all situations, either. A car enthusiast may be willing to spend 20% of their income on a car and reduce their spending on housing by 10% of their income to offset that. Similarly, a family that would rather have a more expensive home may decide to buy a used car and only use 5% of their income on a car to put an extra 5% toward housing.
In general, this rule can help prevent you from overextending yourself when purchasing a car. For financially established individuals, it may make sense to consult this rule for a reasonability check before buying a car. Meanwhile, people on a limited income or those just getting started on their journey into adulthood may find this rule unreasonable. They may need to make adjustments—either up or down—to find a car that fits their needs and budget.
If you want to stick to this rule, here are a few ideas that may help:
This rule may make sense in your situation, or may be an outdated guideline that hasn't kept up with your current reality. Considering the rule before making a purchase can help give you a quick reality check.
The key is realizing only you know what you can afford. As long as your car purchase fits within your budget, you can use this rule of thumb as a guideline rather than a strict rule you must follow.
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