Personal Finance

Use the 10% Rule to Figure Out How Much Money to Spend on Your Car Payment: Here's How to Calculate It

@karly.valencia | Twenty20

This story is part of CNBC Make It's One-Minute Money Hacks series, which provides easy, straightforward tips and tricks to help you understand your finances and take control of your money.

Planning to buy a new, or new-to-you, car is a big decision. And before you sign on the dotted line, it's important to understand how much it will really cost you.

When browsing your options, keep in mind that financial experts will typically tell you to spend less than 10% of your monthly take-home pay on your car payment. That means if your take-home pay is $3,000 a month, plan to spend no more than $300 on your car payment. 

Next, do some research to figure out the interest rate you're likely to qualify for. This is largely affected by your credit score, so it's different for each person. But generally, the higher your credit score, the lower the interest rate you'll get. 

If you're buying a new car, the average interest rate for someone with a credit score between 661 and 780, which is considered in the 'good' range, is 4.71%, according to Bankrate. The average interest rate for someone with a credit score between 501 and 600, which is considered poor to fair, is 11.33% — a major difference.

And keep in mind that although used cars are typically cheaper, interest rates for pre-owned vehicles tend to be higher. When buying used, the average interest rate for someone with a credit score between 661 and 780 is 6.05%, according to Bankrate. For someone with a credit score between 501 and 600, it's 17.78%.

From there, you'll need to decide on the term, or length, of your auto loan. As of the second quarter of 2020, the average loan term for a new car loan is about 72 months, or six years. Car loans have been getting longer in recent years, with 72- and 84-month loans replacing the more traditional 48- and 60-month loans, Experian reports.

The longer you spend paying off the loan, the more you'll end up paying in interest. That can bust your budget, even if a longer loan reduces your monthly payment.

Here's an example: Say you want to buy a $30,000 car (the average price of a new car is around $40,000) with an APR of 5% and no down payment. If you take out a 60-month loan, that comes to a payment of $500 a month. But don't forget that you also have to pay that 5% interest, so your monthly payment actually comes out to around $566.

Over 60 months, or five years, you'll end up paying a total of about $34,000.

That's a pretty hefty monthly payment. Say you lengthen the loan to 84 months, or seven years, which bumps the monthly payment down to about $360 a month. With the continued interest, you'd actually pay around $424 a month and spend more than $2,000 more for a total of about $36,118.

And don't forget that the monthly payment isn't everything. You also need to budget for insurance, gas, maintenance and other expenses, which shouldn't cost more than another 5% to 10% of your take-home pay. 

You should consider all of these factors together when calculating how much you'll actually be spending on your car each month.

Check out: Meet the middle-aged millennial: Homeowner, debt-burdened and turning 40

More from this series: This simple money hack could help you boost your retirement savings by $20,000 or more

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