Those contemplating taking out an auto loan usually do so because they need a new vehicle. The process to obtain that vehicle often begins with a prospective borrower finding a car they like-and then trying to work the budgeting process out. While this approach may be sound, it should be taken only by those who are willing to change their vehicle selection if their budget doesn’t allow for such a purchase. How does a borrower know what their budget will afford them? There are several approaches, but arguably one of the healthiest is through a simple 50/30/20 plan analysis.
What is the 50/30/20 Plan?
The 50/30/20 plan is one touted by Harvard Bankruptcy professor, Elizabeth Warren. This plan is usually used to manage one’s debts and avoid bankruptcy, but it can also act a wonderful tool for an individual trying to determine how much they can afford for any purchase — auto loans included.
This plan works by dividing one’s income into three categories: needs, wants, and savings. Needs are given top priority, and thus are allotted 50 percent of one’s income. Wants are given 30 percent of one’s income. Savings, while it may seem rather high, receive 20 percent of one’s income. It’s due to this personal revenue spread that the plan receives its name: the 50/30/20 plan.
Needs: Our Most Important Purchases
The girth of an individual’s income should be devoted to their needs. Needs account for more than simply food, water, and shelter, and instead cover everything that we “must have” in order to operate successfully and healthily in our modern society. One should lump their house payment (or rent), utilities, transportation, food, medicine, insurance, education, child care, and minimum loan and financial obligation payments.
That qualifier “minimum” is important for outstanding loan and financial obligations because making the minimum payment is all one “needs” to do in order to continue staying financially afloat.
To expand on this, consider a cell phone plan. One can obtain a basic cell phone plan for a relatively small amount of money. But, as often is the case, we want smart phones that can do everything from telling us where we’re driving to connecting us with friends in a virtual gaming world. We only “need” to talk in emergency cases, so the amount of a basic plan should be all that’s lumped into this category. Any additional cost we willingly take out will be put into the “wants” category.
Wants: Everybody’s Favorite
The next largest portion of income will be set aside for our wants. This is the category we’re most familiar with: entertainment, clothing, vacations, gifts, alcohol, video games, movies, restaurants, make-up, and financial plans that go above and beyond the basic are some of the expenditures that are “wants.”
This is where the additional smart-phone or unlimited texting charges would be included. Likewise, any desired amount above and beyond the minimum outstanding loan payments would belong here for the same reason.
Savings: The Staple of Financial Responsibility
Finally, 20 percent of one’s income should be devoted to savings. The reason why this number is so high is because it is so crucial. Setting aside one-fifth of cash flow on a monthly basis allows an individual to take real steps towards building a reserve for the future.
Whether savings are used for a large down payment or act as a cushion against job loss or sudden emergencies, raking 20 percent of one’s monthly income allows for a safe and adequate buffer between the individual and cruel world of the unexpected.
Where Auto Loan Affordability Fits Into This
Borrowers can determine exactly how much they can afford on a recurring auto loan bill by doing a 50/30/20 analysis using their own personal income and their individual expenditures. However, when determining a healthy car loan payment, borrowers should omit the price for any current expense that pertains to an existing mode of transportation.
Then they can take a look at the amount leftover in the needs and wants category, and whatever that amount is they can use towards vehicle financing. If the car they desire will not yield monthly payments in accordance with what the borrower can afford, then they should either pursue a different vehicle make or continue to save money for a larger down payment.
By sticking to this 50/30/20 plan, borrowers can assure themselves they are making healthy and affordable car loan payments while simultaneously meeting their other financial needs.
After covering the world of home mortgage loans for three years, the writer of this article, Alex Gomory, is proud to have expanded his scope to the entire financing industry as a whole. To further learn about auto loans and read more of Alex’s articles and news stories, visit http://loans.org/, where he and other staff writers continuously publish articles on a near daily basis.