Financing a new car or truck is a lot like a marriage. There are fundamental things that must be discussed in the beginning that could have a huge impact on your life later on.
With a marriage, you have to agree on subjects such as money, children, religion, and life style from the outset, or else any difference you may have with your partner will represent a crack in the relationship’s foundation that will eventually lead to problems.
Financing a car is remarkably similar. The amount of the payment and length of the repayment term may not seem like a big deal when you are focused on simply bringing the car home, but over time, the auto loan will have a positive or negative impact on your everyday life. That is why it is good practice to follow the 20/4/10 rule, and to first ask yourself: “How much car can I afford?”
What Is the 20/4/10 Rule?
On the surface, the 20/4/10 rule seems very simple. It essentially states that:
- 20: your down payment should always be at least 20% of the vehicle
- 4: you should finance your vehicle for four years or less
- 10: you should keep your total monthly vehicle expense to less than 10% of your gross monthly income. Monthly vehicle expense include the car payment as well as insurance and gas.
Lately, there has been a lot of debate regarding this approach. Opponents will state that you should never finance a vehicle because it is a depreciating asset. But with apologies to cash-only proponents like Dave Ramsey, the best personal finance advice is always rooted in reality — and the reality is that most people do not bring a few bags of cash with them to buy their next car or truck.
Instead of feeling bad about having to take out a car loan, just be smarter about it. Following a rule that helps you never end up in a negative equity position and keeps your monthly outlay to less than 10% of your gross income should assuage many of the fears regarding financing a vehicle in the first place.
Putting the 20/4/20 Auto Loan Rule into Action
Whether you’re a numbers person or not, seeing the application of the 20/40/10 rule can help you get a feel for what kind of car loan options you can really afford. Let’s go through a basic example.
1) Look at Your Financial Situation First, Cars Later
The first fundamental shift is to change your starting point. In the past, you probably started your car shopping experience by finding a car that you like, then figuring out how you can afford it.
Shifting back away from marriage counseling, car buying should take a similar approach. Figure out whom you are…financially. Then you can start your search.
2) Assessing How Much Car You Can Afford
Next, ask yourself some basic questions. How much money do you have available for a car down payment? What is your gross monthly income? Is your credit good enough to get approved for a car loan? Let’s start with those three basic ones:
- Assume you have $5,000 for a down payment.
- Also, let’s assume that you make $40,000 per year, so that means your gross monthly income is roughly $3,333 ($40,000 / 12 months).
- For this exercise, let’s also assume you can qualify for an auto loan.
3) Applying the 20/4/10 Rule to Your Car Loan
Given this financial reality, the first qualifier is to see how much you can afford simply using the 20% down payment rule. Since you have $5,000 available, the maximum price of the car you can purchase is $25,000 ($5,000 / 20%).
The second step just tells you to not finance more than four years.
The third step states that your payment should not be more than 10% of your gross monthly income (GMI). We determined that your GMI is $3,333, so 10% is $333 ($3,333 x 10%). Assuming your insurance is $75 per month, then you have $258 available to use on your monthly principal and interest payment. Using auto loan rates of 3% (there are lower out there) and a term of 48 months, the maximum amount you can finance would be $11,650.
Therefore, the most you can afford is $16,650, which represents that $11,650 plus the $5,000 you have available for a down payment. That is a far cry from the $25,000 from the first step.
No system is foolproof, and it is necessary to understand that you may have other considerations such as other debt or income that is not stable. The essential takeaway is to understand the approach. Start with understanding your financial position and work backwards. Do not fall in love with a car and try to figure out how to afford it. We can be excellent liars (especially to ourselves!) when it comes to money.