Buying a car? Know your budget, save up, plan in advance

Car-shopping should be the last step; knowing what you can afford, the first

By Gary Foreman

The New Frugal You

Gary Foreman is a former financial planner who currently edits The Dollar Stretcher website and newsletters. He writes "New Frugal You," a weekly Q&A column about frugal living, for CreditCards.com Ask a question. 'New Frugal You' archive

Dear New Frugal You,
I need a realistic, step-by-step approach on how to save up for a new or used car. My husband is going to need one in the not-so-distant future, and I'm not sure the best way to save, invest, etc? Can you shed some light on this issue? Thanks in advance! -- Brenda

Dear Brenda,
That's a really good question. Most people put the cart before the  horse. They buy a car or truck and then try to figure out how they're going to pay for it. And often they get in trouble because they've spent more than they can really afford. Your plan -- to prepare long before you start shopping for the car -- will work out much better.

Begin by finding out how much car you can afford. Most family budgets can handle 15 percent of take-home pay for transportation -- perhaps 18 percent if you're willing to sacrifice spending in other areas. If you try to spend more than that, you'll start running into problems. Transportation includes any car payments, insurance, maintenance and gas. Even garage rental and license plates.

Once you calculate how much you can spend each month on transportation (your monthly take-home pay times 15 percent), subtract the cost of insurance, maintenance, etc. What's left is what you can afford to spend each month on a car payment.

Here's where you have a big advantage. Because you're planning ahead, you can "test run" your budget. Begin to save your car payment each month now. Instead of writing a check to the lender, write one to your savings account. If the payment is too big, you'll discover it in a month or two. It's much better to find out now: Once you've bought the car and committed to years of payments, it will be too late.

The next question is where to stash the money you're saving. The temptation is to try to get the highest return on that money. That could lead you into big trouble.

Remember that you don't want to lose the money that you've saved. It would be a shame if you're ready to purchase a car and your investment choice managed to lose some (or all) of your principal.

Because you want your money safe and liquid (meaning, available when you want it), your investment choices are pretty limited. You'll probably want to limit yourself to a savings account, money market fund or very short-term CD.

None of those options will pay much interest, but don't let that bother you. Since you're going to need that money fairly soon, it won't make much difference. A little higher rate won't earn much more over a short period.

The real deal isn't in how much interest you earn. It's in how much less interest you'll pay. According to Bankrate.com, as of the spring of 2011, auto rates on new car loans are running about 5 percent right now. So for every dollar you save, you'll effectively earn 5 percent for the life of your auto loan. That's where the savings are!

Another advantage to planning ahead is that you'll know exactly how much you can afford in a monthly payment. Be prepared when you go car-shopping. One way to get you into a more expensive ride without raising the payment is to stretch out the loan.  Don't. It's a trap. You'll spend too much time "upside down" in your car loan -- that is, owing more than the car is worth. If you should need to trade, your options will be severely limited.

Next, when you're getting ready to buy, shop around for your auto loan.

See related: Getting a car loan after bankruptcy, Can you really afford that car loan?, Can quickly repaying a car loan help your credit?, Yes, you can put a car on a credit card -- carefully

For more than 35 years, Gary Foreman has worked to help people get the most for their money. Prior to founding The Dollar Stretcher.com, he was a financial planner and purchasing manager. Gary began The Dollar Stretcher website and newsletters in April 1996. Today the website features more than 6,000 articles on different ways to live better for less. Gary has been interviewed by The Wall Street Journal, The Nightly Business Report, USA Today, Reader's Digest and other newspapers and magazines. Gary answers a question about a budgeting or saving issue from a CreditCards.com reader each week. Send your question to The New Frugal You.

Published: March 31, 2011

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