Looking to buy a new car but want to avoid getting into deep debt? The 20/4/10 rule of car buying is a nifty formula to help you decide which car to buy and for what price.
“I guess a few hundred dollars more for these features won’t matter…” is essentially all of us after being suckered into buying a pricier car than what we first considered! It’s easy to overshoot your budget when buying a car – and that’s where the 20/4/10 rule comes in handy. Using it, you can ensure that the car you buy (and the car loan you take) does not end up with expensive payments or high-interest charges.
TL;DR: When buying a car, always try to make a 20% down payment, with a car loan term not more than 4 years, and spend no more than 10% of your monthly income on transportation (including loan payments, insurance, gas, maintenance, etc.)
What is the 20/4/10 rule for buying a car?
The 20/4/10 rule is a useful formula to find whether your desired car will fit in your budget without causing you to end up in debt. According to it:
- The minimum down payment you should make on the car should be 20%
- The ideal car loan term to choose should not be more than 4 years
- You should not spend more than 10% of your monthly income on monthly transportation costs (including auto loan payments, gas, insurance, maintenance costs, etc.)
Typically, sticking to this rule will ensure that your car expenses will not overshoot the budget. When calculating the transportation costs, you can choose either your gross monthly income or net monthly income.
Why should you follow the 20/4/10 rule when buying a car?
According to the data website ConsumerReports, nearly 5% of all auto loans in the country were 90 days past due. That means that thousands of Americans have taken auto loans that they were unable to repay and are on the brink of default and vehicle repossession! This indicates a lack of financial discipline when buying a car, and an overestimation of their ability to repay loans.
The 20/4/10 rule is simple enough for the layperson to understand. The logical reasons to follow it when buying a car are as follows:
Minimum down payment of 20%
Making a down payment seems like a costly measure at the outset. However, the more you borrow, the more will be your interest charges every month. This is compounded by the fact that your car’s value will depreciate by 20% in the first year itself! If you’re not careful, you could end up “underwater” on the loan – owing more than what the car is worth!
Ideal loan term of 4 years
According to the 20/4/10 rule, 4 years is an optimum term. While longer loan terms can get you lower monthly payments, you could end up paying more interest in the long run. For example, with 72-84 month terms, the interest starts to accumulate while depreciation continues to erode your car’s value. If you don’t strike a balance between the two, you could again end up underwater on the loan.
Transportation costs capped at 10% of your income
Purchasing a car is only the first step! Between rising gas prices, high monthly loan payments, insurance charges, and spiraling maintenance costs, American families have been paying a whopping $820 every month on transportation. The 20/4/10 rule specifies that you should ideally limit transport expenses to 10% of your gross income (i.e., income before taxes and other deductions). But is that even possible these days?
One solution is to sign up for a car services subscription that helps you save money by bundling several auto services together. For example,a Way+ subscription can help you save on everything from auto insurance, refinance, parking, and gas.
What happens if you don’t use the 20/4/10 rule of thumb?
Let’s see how the 20/4/10 rule works practically.
Consider John Doe, a potential car buyer, who has an annual salary of $48,000 – or $4000/month. According to the 20/4/10 rule, if John wants to buy a car for $40,000, his ideal car expenses to prevent going “underwater” are:
- A down payment of $8000
- A 4-year loan term
- Total transportation costs should be within $400
Unless he can fulfill these conditions (with slight changes based on his credit score), he will find that the car depreciates faster than his ability to pay back the loan.
When is the 20/4/10 rule not applicable?
While it sounds good to hear, the 20/4/10 rule of buying a car may not hold up in all situations.
For example, the prices of both new and used cars have been rising in the past year, with no signs of moderation in the near future. Gas prices have been averaging more than $4 per gallon, while car loan payments have also crossed $600/month. With wages failing to keep up with price rises in the economy, you may have to make compromises on this rule.
Is the 20/4/10 rule flexible?
- You can pay a 20% down payment if you reduce your spending on housing/personal loans by a certain amount
- You can also extend the loan term to 5-6 years if you want to prioritize low monthly payments
- Instead of buying a new car, you can buy a used car that only needs a reduced downpayment and costs less to pay off
- Saving on car services with an all-in-one auto app like Way.com can also help keep your overall transportation costs to 10-15%
The 20/4/10 rule is merely a guideline that can help you distinguish between excellent and terrible financial decisions when buying a car. There is always a bit of legroom you can use, so exercise your judgment when you’re car shopping.
Frequently Asked Questions (FAQ)
What is the 20/4/10 rule for how much to spend on a car loan?
The 20/4/10 rule dictates that to prevent yourself from ending up in a bad car loan, you should:
- Make a 20% down payment at the start of the loan
- Have a loan term not longer than 4 years
- Keep your transportation costs to within 10% of your gross income
What is the 20 in the 20/4/10 rule for car buying?
The 20 in the 20/4/10 rule stands for the 20% minimum down payment you are recommended to pay when buying a car.
20/40/10 rule: what does the 4 stand for?
The 4 in the 20/4/10 rule stands for the recommended length of the loan term: 4 years.
20/4/10 rule: what does the 10 stand for?
The 10 in the 20/4/10 rule stands for the recommended upper limit for transportation costs per person. Ideally, it should be within 10% of a person’s monthly income.
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