Once you decide you want a new car, the first thing you should do is figure out how much car you can afford. Calculate this amount before you go shopping; don’t let a car dealer influence your decision.
Figure out how big a loan you should get. A good rule of thumb: Your monthly car payment should be no more than 20% of your disposable income. That means that after you’ve paid all your debts and living expenses, take one-fifth of what’s left. That’s your maximum monthly auto expense. Ideally, this number should cover not only your car payment, but also your insurance and fuel costs.
Decide how long you’ll give yourself to repay your car loan. The more months you have to pay it back, the lower the monthly payment will be. But stretching out a car loan too long—or any loan, for that matter—will ultimately cost you more in interest payments.
For example, say you take out a $20,000 car loan at 5%. If you borrow the money over four years, your monthly payment will be $460.59. At the end of four years, you’ll have paid $2,108.12 in interest.
If you borrow the money over ten years, your monthly payment will only be $211.12, but at the end of 10
years, you’ll have paid $5,455.72 in interest.
Keep your loan term to five years or less (three is ideal) and you should be in good shape. If the monthly payments are too much even at five years, the car you’re looking to buy is probably too expensive.