Monthly payments: How much debt should you have?
Too much debt is clearly not a good thing. It puts you under stress and can spell disaster if you have an unexpected emergency or get laid off from work. Americans learned the danger of too much debt all to clearly during the recession of 2008-2009 with many folks losing their homes due to being too deep in debt.
As was noted earlier, many experts recommend that your total debt-payments not exceed 33% of your gross monthly income. That’s ALL your debt payments by the way… including credit cards, rent/mortgages, etc. To restate the example from earlier, use the following steps to determine how much you can afford:
- Determine 33% of your gross monthly income.
- List all your monthly obligations, including your rent or mortgage payments, credit card payments, and any other type of consumer/installment loans; and then calculate a total.
- Subtract the “monthly payment total” from 33% of your gross monthly income. This is the maximum debt payments you should have.
To show this in a real-world example, if your pretax income is $50,000, your total payments toward debt should not exceed $16,500 a year. Now, assuming your existing debt payments equal $10,000 a year, you can afford to pay $6,500 annually, or around $540 a month, towards your car payment.
But, just because you can afford a $500-plus payment doesn’t mean you should. So, before you decide to buy the car that will max out your payment, you should keep the following in mind: the longer the term of your loan is, the more money you will pay. Not only will you be paying interest for a longer time period, but your interest rate in most cases will also be higher. A few years down the road, you may wish you had those extra interest payments to back in your pocket to let you pay for a new car. Luxury has a cost. Consider the following example:
Assume that you can afford to pay $8,000 annually ($667 a month) toward your car payment. All banks offer differing rates depending on the length of the loan you want or can afford. Bank A, for example, could charge interest at 6.9% for a 36-month auto loan and 7.34% for a 60-month auto loan.
The 36-month loan will get you approximately $24,000 value worth of car.
The 60-month loan will get you approximately $40,000 value worth of car.
However, as the years progress, you’ll be making payments for two extra years on the 60-month loan. Over the lifetime of that loan, you’ll pay thousands of dollars more in interest on a 60-month term as opposed to the 36-month term. By simply cutting down the length of your loan, you can save yourself a significant amount of money.