Buying a car? Know the 20/4/10 rule

Quick insights

• The 20/4/10 rule for car buying is a sort of affordability calculator.
• The rule suggests that you put 20% down, finance for four years or less and have monthly transportation costs below 10% of your income.
• While the 20/4/10 rule can help calculate your purchasing power, buying a car requires a careful look at your financial situation.

Despite the many options for buying a car today, the financial side of the process is nothing new. You need a way to pay for a car at the time of purchase and often on a monthly basis afterward. How do you know how much you should spend on a car? The 20/4/10 rule might help with the calculation.

What is the 20/4/10 rule?

The 20/4/10 rule is a guideline that focuses on three things when you’re buying a car. The rule suggests you put 20% down and have a maximum loan term of four years. Plus, you should maintain transportation costs each month that are no more than 10% of your gross monthly income.

How does the 20/4/10 rule work?

Here’s a breakdown for each part of the 20/4/10 rule for car buying.

20% down payment

There are a couple reasons why a 20% down payment is a good objective when financing large purchases. In general, the down payment affects the terms of a loan, including if you qualify, the loan amount and the interest paid over the whole term. The down payment also creates equity in a car as soon as you buy it.

Choose a four-year term or less

Loan terms can range in length, but shorter terms accrue less interest as long as all payments are made on time. Shorter loan terms may also have lower interest rates, which lower monthly payments. For these reasons, four years is generally a good term for a car loan.

Keep transportation costs below 10%

Transportation costs include all of your car-related expenses: monthly car payment, car insurance premiums, maintenance and fuel costs. The 10% recommendation in the 20/4/10 rule is based on your monthly gross income (your pay before taxes).

Pros and cons of the 20/4/10 rule

The 20/4/10 rule, while a useful calculator, has specific pros and cons.

Pros

• Budgeting: When preparing to buy a car, the 20/4/10 rule provides real numbers that you can relate to your budget. Each part offers different information: an amount to save up, how long you’d have payments and a monthly total that may be affordable.
• Equity: Predicting your car’s value over time isn’t an exact science. However, putting 20% down for a four-year term may prevent an upside-down car loan, which happens when you owe more on the car than it’s worth. It can be caused by smaller down payments and longer loan terms.

Cons

• Cash requirement: The amount of a 20% down payment will fluctuate with the purchase price of a vehicle you buy. You’ll have to save for the down payment, and 20% might delay a purchase depending on your budget.
• Inflexibility: Strictly following the 20/4/10 rule might limit the vehicles that fit in your budget. For example, a four-year term could result in a significantly higher payment than a longer loan term would, a possible challenge when trying to meet the 10% part of the rule.

Ways to stay within your 20/4/10 budget

The 20/4/10 rule can be helpful in putting real estimates on a potential car purchase. You’ll have to relate the figures to your budget, though. Here are some tips:

• Know your monthly budget: This may be the most useful way to determine how much you can spend on a car. Your budget will indicate what you can afford to save for the down payment and then spend on transportation costs each month.
• Calculate potential costs: An affordability calculator can estimate monthly payments, and you can also get quotes on insurance premiums. Don’t forget to estimate the costs of fuel and routine maintenance.
• Save for the down payment: You can take the percentage of a car’s price to determine how much you have to save.

In summary

The 20/4/10 rule can be a helpful guideline when preparing to buy a car. The 20/4/10 rule is not a one-size-fits-all formula for calculating how much you should spend, but it can lead to a sound financial decision. Your individual finances and circumstances will help determine how closely you’ll follow the rule.