NEW YORK (MainStreet) — Consumers who view the monthly payments as a guide to determine how much to spend on a new house or car are making a mistake, because many people tend to overspend when using this logic.
While the lower payments mentioned by a real estate agent or salesperson may sound like a good idea, both purchases have many hidden costs that can put most shoppers over their ideal debt-to-income ratio of 40-to-60 -- meaning home and car payments in total do not equal more than 40% of household income.
“There are two people who should never define your capacity to afford a loan: the salesperson and the lender,” said Bruce McClary, spokesperson for the National Foundation for Credit Counseling, a Washington, D.C.-based nonprofit organization. “It is up to you to determine if the loan you have been approved for is going to be affordable.”
How Much to Spend On a Car
Too many consumers have high monthly car payments, because they purchased vehicles out of their price range. Don’t be lured by the gimmicks of advertisers of low interest rates. Some experts recommend following the “20/4/10” rule which calls for a 20% down payment, financing lasting no longer than four years and no more than 10% of a person's gross income to be devoted toward the principal, interest and insurance.
“The dangerous habit consumers have is they shop on the basis of the monthly payment without adequate consideration for the total costs they are going to incur over the term of the loan,” said Greg McBride, chief financial analyst for by Bankrate, the North Palm Beach, Fla.-based financial content company.
One rule of thumb to follow is to avoid taking out a car loan for more than five years. If you chose a longer term, then it is a “sign that you are biting off more than you can chew,” McBride said. Think about how long you want to keep the car, because if the loan term is longer, then you are headed for trouble. Avoid stretching out the term of the loan so you can lower your monthly payments.
Although many people do not have a lot of spare cash for a down payment, putting down 10% for a new car and 20% for a used car will give you a “cushion considering the rapid depreciation after you buy the vehicle,” McBride said. Just because you can purchase a car with a minimal or no down payment, it is still a good idea to make one because you will pay less in interest. Used cars require a larger down payment, because they are more prone to breaking down.
Factor in your costs for a warranty, sales tax, gas, insurance, maintenance and repairs that you will incur. A shorter loan means that the balance of the loan will decrease faster than the rate of depreciation of the car or truck, McClary said. Although some reports have found that the average consumer spends 11% of his household budget on a car payment, the recommended allowance is 8% or less, he said.
Other drivers are not even remotely close to achieving these rules and are compounding the problem by rolling over negative equity from their trade-in. If you still owe money on your previous car, meaning that you are underwater on the loan, the result is that the negative equity gets rolled into the new loan. If you still owe $2,000 from your previous loan, then the $25,000 car becomes a $27,000 auto loan.
“The moment you drive off the lot, it is no longer worth $ 25,000 and depreciates dramatically to a market value of $20,000,” McClary said.
The best advice for consumers trying to tackle other debt such as student loans or credit cards is to keep a car for a longer period.
“Life without car payments is good,” McBride said. “You want to get to that point where you are no longer on the treadmill of monthly payments. Keep your car and drive your way out of debt.”
Many lenders are less merciful when it comes to missing a car payment and repossession is more likely to be on the table. Some lenders will repossess the vehicle “as soon as a payment is missed in some cases,” said McClary.
What to Spend On a Home
Although a mortgage lender will approve you for a loan that is much higher than you can afford, it does not mean you should go for it. Homeownership can be costly, with added fees such as mortgage insurance, property taxes, house insurance, maintenance and a homeowner’s association fee.
Some real estate agents will tell you that obtaining a mortgage for two or three times your salary is an adequate guideline, but in some cases that is far too generous.
The problem is that people want the “biggest, nicest house they can get,” said McBride. “There is that tendency to borrow as much as you are able to, and it’s not always a good financial decision.”
During the previous housing boom, many consumers found themselves in trouble, because they only focused on the monthly payment and compared it to their rental payment cost. What was lacking was a consideration for what occurred down the road such as when the interest rate of a homeowner’s adjustable rate mortgage rose without a commensurate salary boost.
The best method to measure if the price of a house is affordable is to base it on a traditional 30-year fixed rate mortgage, McBride said.
“If you can’t afford a payment on a 30-year mortgage, you’re not looking at the wrong loan, you are looking at the wrong house,” he said said.
Consumers should not devote more than 30% of their income to a mortgage payment, which includes property tax and insurance. To boot, the amount of the mortgage should not be over three times of your gross salary, McBride added.
Bringing It All Together
The best approach is for consumers to allocate no more than 10% of their income to an auto loan and 30% to a home. Many mortgage lenders will not approve potential homeowners if their total debt exceeds 43% of their income. This means that student loans and credit cards should be factored into the equation as well, McBride said.
“That’s why it pays to keep these ratios low because it’s not the payment you don’t have today, but the ones you might have in a few years,” he said.
Mortgage lenders tend to be more tolerant if you miss one or two payments. While a foreclosure typically cannot start until your mortgage is at least 120 days past due, it is a serious problem, said McClary.