Once you decide you want a new car, the first thing you should do is figure out how much car you can afford. As we said in Section I, don’t let your dealer help you with these calculations. Do them yourself before you go shopping.

1.) Figure out how big a loan you should get: A decent rule is that your monthly car payment should be no more than 20% of your disposable income. That means that after you’ve paid all your debts and living expenses, take one-fifth of whatever’s left over and that’s your maximum monthly auto expense. Keep in mind that, ideally, this number should not just cover the car payment, but also your insurance and fuel costs for the month.

2.) Decide how long you’ll give yourself to pay your car loan back: A monthly payment is, essentially, the amount of your loan, plus interest, divided over the number of months you have to pay back the loan. The more months you have to pay it back, the lower the monthly payment will be. But stretching out a car loan—or any loan, for that matter—will ultimately cost you a truckload more in interest payments. Here’s an example:

You get a $20,000 car loan at 5%. If you borrow the money over four years your monthly payment will be $460.59. At the end of four years, you’ll have paid $2,108.12 in interest.

If you borrow the money over 10 years, your monthly payment will only be $211.12, but at the end of 10 years, you’ll have paid $5,455.72 in interest.

Keep your loan term to five years or less (three would be ideal) and you should be in good shape. If the monthly payments are too much even at five years, the car you’re looking to buy is probably too expensive.

3.) Consider all pools of money.
Should you sell investments to pay for the car instead of borrowing at 7%? Well, that’s a tough call. For Pete’s sake, do not spend any of your tax-sheltered retirement savings (IRAs, 401ks), as you’ll pay through the nose in penalties and taxes. As for taxable investments, consider whether cashing out would have lousy capital-gains implications (you’ll pay 15% for investments held longer than one year; investments held less than a year are taxed at your ordinary income-tax rate) or what you might need that money for in the next two to three years, if anything.

Should you take out a home equity loan since the interest of that loan is tax-deductible? Many people think home loans are the perfect way to finance a new-car purchase. Many people are wrong. The problem with home loans is the length of the term—most require payments over at least 10 years. Financing your car purchase over that amount of time is going to send your total costs through the roof, even after you’ve accounted for the tax deduction. Remember, borrow for no more than five years, lease (if you have to) for no more than three. If you’re considering a home-equity line of credit, remember that most HELOCs have a variable rate, so it’s possible that your payments will rise over time.

Want to Know More?

• How to Buy a Car (And Deal With the Dealer)
• How to Get the Best Deal
• Grilling Guide: Questions to Ask When Financing a Car