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Related topics: savings, car insurance, car loans, used cars, Liz Weston

A reader once called me out on my advice about car buying.

I had suggested that if you can't pay cash for your next car, you should make a down payment of at least 20%, finance the balance for four years or less and make sure the resulting payment is no more than 10% of your gross income.

This reader did the math and sputtered, but that means the typical U.S. family can't afford the typical new car!

Precisely.

Someone who purchased a new car in 2009, when the average price was $28,966 according to the National Automobile Dealers Association, would have needed a household income of nearly $65,000 to swing a purchase under my formula. That assumes a 5.75% interest rate, which Edmunds.com says was the average paid by buyers who financed new cars in 2009. The latest statistics from the Census Bureau show median household income was about $50,000 in 2008. "Median" means half of all U.S. households earned less.

And spending 10% of your gross income on a car is actually too much for many people. If you've got a big house payment or other significant debts, you should spend less -- maybe a lot less.

Liz Weston

Liz Weston

Car dealers have been pretty clever about disguising the fact that most households can't afford their new cars. They do this by:

  • Stretching out your loan term. Nine out of 10 new-car loans are now for longer than four years; some are as long as nine years. Longer loan terms lower your payments, which make them seem more affordable, and the lender wins because you end up paying a lot more interest. You also stay in debt longer, pay a lot more for your cars and often remain "underwater" -- owing more than the car is worth -- for most of the time you're paying it off.
Borrowing $25,000 at 5.75%
Loan termPaymentTotal paid
3 years$758$27,288
4 years$584$28,032
5 years$480$28,800
6 years$411$29,592
7 years$362$30,427
  • Not insisting on down payments. Allowing you to finance all or almost all of your purchase means lenders can charge higher interest rates. It also ensures you're underwater on the loan from the minute you drive off the lot, thanks to depreciation (a car's value drops 10% or more as soon as it's no longer "new"). You don't even have to pay off your old loan; in one out of five purchases, debt from the previous vehicle is rolled into the new loan. The typical amount of negative equity is around $3,700, Edmunds.com says.

It used to be worse. At the easy-money peak, 30% of loans included debt from a prior vehicle. Even after the rate drifted down to just more than 20% in 2008, the average amount of negative equity swelled to about $4,500.

There was a brief moment in the summer of 2009 when it seemed the tide was turning against underwater loans. As credit dried up, auto lenders got a lot pickier about who got money; by that August, only 8% of sales involved negative-equity loans.

But lender reticence quickly vanished as car sales plunged. By September, we were back to 19% of sales including debt from a past loan.

In the end, you'll pay . . . and pay

The results of these loan practices are disastrous for many people. Car buyers spend too much to start with and then find their overall costs -- including insurance, gas, maintenance, repairs and taxes -- mean they're paying twice the sticker price over time.

If the car is stolen or totaled, their pain is just beginning, because the check they'll receive from their insurer is likely to be far less than what they owe. Unless they bought gap insurance, they'll wind up owing a big wad to their lender while trying to figure out how to get their next set of wheels.

When you overspend on cars, you don't have enough money left over for more-important goals, such as saving for retirement, paying down debt or building up an emergency fund.

It's time to end the madness. A new car is not a birthright; it's a luxury. And luxuries should be paid for in cash. As author Jeff Yeager notes in his new book, "The Cheapskate Next Door," too many Americans accept car payments as a permanent fact of life when they would be far better off buying used and paying cash.

Here's your action plan for vehicle sanity:

  • Find out what your car is worth. (You'll find Kelley Blue Book values on MSN Autos.) Compare it to what you owe. If you're underwater and you don't have cash sitting in savings to make up the difference, buy gap insurance to protect yourself.
  • Drive your current car until it's paid off. Then redirect the amount of your payments into a dedicated savings account for your next car. If you don't accumulate enough to buy a new car when your current car dies, get a used one. You can save a boatload of money over your lifetime simply by eschewing the new-car smell.
  • Consider your alternatives. Cars cost a lot. The typical U.S. household spends more than $8,000 a year on its vehicles. Isn't there something else you would rather do with that money? Getting by with one less car, or no car, is possible in many areas served by public transportation and shared-vehicle services such as Zipcar. Plenty of people do it: Check out this "life without a car" link for more.

Liz Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "The 10 Commandments of Money: Survive and Thrive in the New Economy" (find it on Bing). Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. Join the conversation and send in your financial questions on Liz Weston's Facebook fan page.