Today, I will go through the 20/4/10 rule to figure how much can you afford for a car and give my own opinion on this subject
Cars are the most expensive item that we buy that goes down in value and we generally start buying them at a pretty young age, so figuring out how to buy a car the right way is very important for our financial Future.
In this post, I’ll explain what the 20/4/10 rule is? When it should be used? And give my overall thoughts on the rule as well as talk about some possible alternatives for saving up for a car.
What is the 20/4/10 rule?
Well, it’s a rule of thumb to help you try and figure out just how much you should be spending on a car purchase.
It basically goes like this:
- You must put at least 20% down on your car similar to how you would with a home.
- You must finance the car for no more than 4 years.
- And you must keep the total monthly vehicle expenses which include principal and interest payments, insurance, and some people even include gas under 10% of your gross income for the month.
Example 1: How much can you afford for a car
So, let’s put some numbers to this, for example, let’s say that you had a $60,000 a year household income this means that your monthly gross income is about $5,000
If you were to follow the 20/4/10 rule when looking to buy a new car you would, therefore, need to keep your total monthly vehicle expenses under $500 which is 10% of your monthly gross income
Now, on the one hand, this is nice because it does limit you to a certain extent when buying a new car, it does force you to at least put something down on the loan and it does shorten the length of the loan, at least in comparison to the average length of a car loan which is between 5 and 6 years long
This means that your monthly payments on the car are likely going to be a little bit higher than for someone else buying the same car but having a longer loan period so it makes you a little less likely to buy a car that you can’t truly afford because you see exactly what the payments are going to be.
Example 2: let’s see How much can you afford for a car
Without the 20/4/10 rule
Let’s take a look at another example, let’s say that John took out a $25,000 car loan and didn’t follow the 20/4/10 rule, meaning that he did not put down 20% on the car so he has a $25,000 loan that is charging him an interest rate of about 4.4%, which appears to be right about average at the time I’m writing this post.
His loan term is 60 months and his monthly payment is about $465.
If you add in the numbers you’ll find that he pays nearly $2,900 in interest over the course of that five-year loan or a little under $50 a month on average
And that’s all fine and good but what if John had followed the 20/4/10 rule?
With the 20/4/10 rule
His loan would have been for $20,000 because he would have made a $5,000 down payment and the loan would have lasted 4 years instead of 5
This means that assuming the interest rate was the same, he would have a monthly payment of $455
Yeah, it’s actually lower than the previous example
And he would only pay $1,850 in interest but it gets even better because he gets out of debt a full year sooner he may be able to take that 5th year, assuming he doesn’t buy a new car of course and use that fifth year to start saving towards his next car purchase
If he did that for the fifth-year, putting $455 a month in the bank, and assuming absolutely no interest whatsoever, he would still manage to have $5,460 in his savings account just waiting for his next car by the end of the year
This is more than enough to make the down payment he made for his current car so you can see that it makes a decent amount of difference
When you should use the 20/4/10 rule
I think that using this rule of thumb is certainly better than using no rule at all and if you find yourself in a situation where you just really don’t have a guide to use for figuring out how much you should be spending on your next car then certainly give this rule a look
However, in my opinion, this rule is great if you want to get a loan but I would prefer to avoid getting a loan in the first place.
My own opinion on how much can you afford for a car
Let me explain, while it’s true that this rule does limit the amount of time you spend in debt with a car loan it doesn’t actually help you to eliminate the need for a car loan in the first place
Now, if you’re in a situation where you absolutely need to get a new car because your old one is basically not running anymore and you don’t have much time to plan out your next car purchase because it has to happen very soon then, by all means, use this rule, again it’s better than using no rule at all
But if you do have a little bit of time in between your next car purchase then ideally what you would do is adjust your current budget so that you can start saving a little money to buy a decent short term used car with cash
Normally I like to buy cars from friends or family members who I know take very good care of their vehicles because that way I get a well-maintained car and they make some money
I know that not everyone in a situation where they can do that so you may have to just go to a used dealer that you trust to get your new car but think of the difference that this can make
Let’s say that you were going to follow the 20/4/10 rule just like John did in the previous example.
We’ll even use the same numbers as before, meaning that John currently has $5,000 in the bank ready to make a down payment
But if he were to, instead of making the down payment, use that money to buy a $5,000 used car thus eliminate the need to have a car payment at all how much of a difference would that make over the next four years?
Because remember the rule states that you can only finance a car for up to 4 years
Just like John’s previous example where he had a 4-year $20,000 loan charging him 4.4% interest, he would have a monthly payment of $455 a month and over the course of that loan he would pay almost $1,850 in interest
However, if he where to go and get the used car and not have to make a car payment he would be able to save that $450 a month towards his next car purchase
Meaning that every single year that he manages to keep that used car running he would be able to put away $5,460 towards his next car, again assuming no interest whatsoever
If he had enough time to shop around and found just for example say a good used Toyota for about $5,000 that had maybe a 150K miles on it and he took care of it he might be able to get it to last maybe 2, 3, or even 4 years depending on how well it was taken care of beforehand
And this isn’t an ad for Toyota; it’s just that I know that they’re generally known to run pretty well for a fairly long time if they’re taken care of.
And if the used car manage to last for 2 years that means he would have roughly $11,000 in saving for his next car purchase
If it lasted 3 years he would have roughly $16,400 and if it lasted the full 4 years he would have roughly $21,900 sitting in his savings account for his next car purchase
And depending on what kind of car he actually wanted to buy next that may be almost enough to purchase it in cash and then he’ll never have a car payment again
Other things to take into consideration
Now, obviously there’re other variables that can come into play when making a car purchase such as resale value and maintenance cost on a vehicle but if you’re looking at getting a new car I’m assuming that you already have maintenance cost for your current car
So ask yourself, would the used car immediately have more monthly maintenance costs?
Well, maybe it depends on what your current costs are and how good of shape the used car you’re looking at is in
But even if it is, I doubt it’s going to be a $400 to $500 a month more in maintenance cost more than what you’re currently paying
So you may not be able to put away the full $450 a month or whatever your own number comes out to be in your situation but you should be able to get ahead
And I know that some people just don’t like buying used cars, my dad was one of those people so I do want to say that this isn’t a long-term thing or at least it doesn’t have to be if you don’t want it to be
Again, if you’re putting away roughly $450 a month like in the last example and the first car last just for 2 years and you take care of it while you have it for those two years and you sell it for say $2,000, you’ve saved roughly $11,000 in your first 2 years of car ownership because you didn’t have a car payment and in addition to that you make the $2,000 from the sale meaning that you have nearly $13,000 to spend on your next short-term used or maybe even newish car depending on what you’re looking at
Or let’s say you put it into something with a little bit more resale value like say a Toyota Tacoma and you drive that car for another 2 years then sell it for say $8,000 which is probably being a little bit conservative based on what I’m seeing on AutoTrader as I’m writing this post
Meaning that when you add in the $11,000 you saved in the last 2 years by not having a car payment you now have nearly $19,000 to spend on your new car
And again, depending on the car you want to buy that may be enough to get it in cash or make a very significant down payment.
Conclusion for how much can you afford for a car
My answer to how much can you afford for a car is that the 20/4/10 rule works just fine if you want to finance a car but in my opinion, buying a used car and avoiding getting a loan is better for your financial future
And if you apply the method that I’ve suggested, in the long-term, you’ll find yourself in a better financial situation.
Thanks for your time
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