What is the 20/4/10 Rule for Car Loans?

There’s a lot more to life than car payments, so it’s important to make a budget before you head into the dealership. The 20/4/10 Rule is simple way to figure out how much you can afford to spend on a car loan.

KEY TAKEAWAYS

The 20/4/10 Rule says: Your down payment should be at least 20% of the car’s purchase price; you should only finance the car for 4 years; and your total monthly vehicle expenses shouldn’t be more than 10% of your income. This straightforward method can work wonders for anyone on the path to purchasing their next vehicle and can save you big-time dollars in the long run.

So grab a calculator and let’s get to work!

WHAT IS THE 20/4/10 RULE?

The 20/4/10 Rule was created by financial experts to help consumers like you calculate their purchasing power. The rule of thumb is that you can afford a car if you can meet these three requirements:

• You can make a down payment of 20% or more.
• You can take out a loan with a term of four years or less.
• You can keep your total transportation costs to less than 10% of your monthly income.

Let’s get into each of these requirements in a little more detail:

20% Down Payment

Lenders want to see your dependability and down payments are a great way to show this. By making a down payment of 20% or more, the overall loan amount will be reduced and your monthly payments will be lower. With a larger down payment, you will also have an advantage when it comes to better interest rates.

Financing For No More Than 4 Years

Extended loan terms can be tempting, but beware! Longer terms come with a big price tag. The rule of thumb is to choose a four-year loan (or less) and you will save in the long run. You won’t be stuck in a cycle of never-ending car payments. Plus, a shorter loan term means you can upgrade sooner!

Transportation Costs Below 10%

When you buy a new car, the last thing you want to think about is an overburdened budget. The 20/4/10 Rule can keep you on track when it comes to your finances by making sure your monthly auto expenses (including loan payments and insurance) total up to less than 10% of your monthly income. This way, you can enjoy your new ride without compromising any of your other financial goals.

HOW THE 20/4/10 RULE WORKS

The 20/4/10 Rule works by making sure you’re not extending beyond your financial means. If you embrace this rule in your car-buying journey, you’ll not only gain peace of mind, but you’ll also be confident that you made a smart purchase aligned with your long-term financial goals. You’ll also avoid unnecessary debt and you’ll have the ability to upgrade your vehicle when the time is right. Most importantly, you’ll be prepared for any other financial surprises that could come your way.

What kind of vehicle monthly expenses should you budget for?

We’re going to do this calculation backwards because your income will determine how the rest of the 20/4/10 rule breaks down. Your monthly expenses should reflect how much you will spend on your new car — including car loan payments and insurance — and should not exceed 10% of your gross income.

Your gross income is the amount of money you take home before taxes and deductions. If your annual income is $50,000 you can afford to spend $5,000 a year or $416 a month on vehicle expenses.

Next, use a car insurance calculator to estimate your monthly insurance payments. In Manitoba, the average car insurance rate is about $90 a month. Take that amount away from $416 and you’ve got $326 left over for your monthly car loan payments, interest included.

If you also want to add expenses like gas or car washes to this amount, you’ll have less money to dedicate to your loan payments.

It’s also not a bad to make a budget for regular vehicle maintenance while you’re at it — we explain how to do that and what some common repairs cost in this blog post about how much to budget for car maintenance costs.

How does loan length affect your monthly payments?

A longer financing term spreads out the loan and makes for lower monthly payments. It also means spending more on interest payments because you’re locked into the contract for longer. Shoppers can afford to buy a more expensive car in the short term, but they really only benefit the lender who makes a bigger profit.

The sweet spot for a car loan term is 4 years or 48 months. This is a reasonable amount of time to pay off a car loan and will keep you from purchasing a vehicle beyond your means.

If we go with the monthly car loan payment budget of $326 we outlined above, you can afford to spend $15,648 on a car financed over four years or 48 months.

Try out our Car Loan Calculator to see how a loan term can affect your monthly payments.

Why is a down payment important?

When you make a down payment on a car you’re reducing the amount of money you need to borrow to make the purchase. Taking out a smaller loan will save you money on interest in the long run.

A little goes a long way when it comes to a down payment, but the ideal amount to put down is 20% of the purchase price of the vehicle. This way you’ll have a significant chunk of the car paid off before you even leave the dealership.

To calculate a 20% down payment multiply the price of the vehicle by 0.20. For that $15,648 vehicle your down payment would be $3,136.

If you don’t have any money set aside take some time to save up and ask the dealership about trading in your existing vehicle — you can always use that amount towards your down payment.

Why is it a good idea to set a budget before car shopping?

Buying a car is one of the biggest purchases you can make, but figuring out how much you can afford to spend on a car can be confusing. The 20/4/10 Rule helps simplify the budgeting process and takes some of the stress out of car shopping.

Remember to make a 20% down payment; finance for 4 years or less; and don’t spend more than 10% of your income on monthly vehicle expenses. Those three numbers cover every major car budget category.

The finance managers at Birchwood Credit Solutions care about your budget and will work with you to find a vehicle that suits your bank account. Give us a call or fill out an online application to start your journey to a new car today.