So you’re standing in the local auto dealer’s lot, trying to decide if you should buy the new $40,000 car or the used one for $20,000. You’ve kicked the tires and done the math. You’d need a loan to buy the more expensive one.
But then you’re wondering How much should I spend on a car? And, even more important, Should I take on more debt?
Stanley Poorman, a financial professional with Principal®, says credit cards and loans are often easily accessible, and people are encouraged to take on debt—even when it’s not a financially healthy choice.
“Sometimes you need to step back and ask yourself how taking on debt will impact your ability to save and invest toward long-term goals,” Poorman says. “Also think about how the new debt payment will affect your cash flow.”
Tip: Decide if you can trim expenses to pay down debt by using our budgeting worksheet (PDF).
Debt questions and answers
1. Do I need to buy this, or do I just want it?
This is your ultimate question. If your house has a leaky roof to replace, that’s a need. A roof is kind of important. More important than, say, putting a big screen TV in every room. That’s a want.
2. How long would it take to save and pay cash instead?
It can take a long time to save enough cash for a car. A car loan may be necessary. But if you want a weekend getaway to a nearby city, you could probably save for that before you go, using cash to cover your expenses.
3. Can I afford this debt?
Consider whether it affects your ability to put money away for emergency expenses. If you can’t build extra savings, you may go further into debt when life throws a curveball.
Also look at how it changes your debt-to-income ratio, which could affect your ability to get credit when you really need it. To calculate your debt-to-income ratio, divide your total monthly debt payments by your gross (before taxes or any other deductions) monthly income. A general rule of thumb: Aim for no more than 36% of your monthly pre-tax income going to fixed debt payments.
4. Do other lenders have better interest rates or terms?
It pays to shop around—it can save you money.
Do your interest rate shopping before you step foot on the car lot, for example. Otherwise, you may take whatever loan the dealership offers. Who knows? You may find a better car loan on your own. (Poorman adds that if you’re getting a car loan, don’t forget to consider additional costs that may be added to the total for registration, tax, warranties, gap insurance, etc.)
Tip: Request your free copy of your credit report so you know how it may affect your ability to borrow.
5. Am I buying something that will increase in value?
A home mortgage or home equity loan can be a good debt. Chances are, in most geographic markets, your home will rise in value over time. Meaning, it can be a good return on your investment.
Compare that to the new phone you want … to replace the one you just bought a year ago. It’s not increasing in value. (See No. 2 above. Can you save up and pay cash instead?)
Next steps
Is debt affecting your ability to save for future goals, like retirement? Log in to your Principal account to see how you’re doing. Don’t have an employer-sponsored retirement account? We can help you set up your own retirement savings with an IRA or Roth IRA account.
