The 20/4/10 Rule: How Much Car Can I Afford?
Buying a new car as your first car is exciting as it allows you to shift from commuting daily to work to having your own daily driver outfitted with the latest features. Having a daily driver is vital when commuting is impossible because the area lacks public transportation routes. Thus, many people look for the best car deals in their local car dealerships to make sure they get the best that they can afford.
Leasing a new car is also an option for people who don’t need a particular car for a long time or those who want to drive new cars every few years. This guide to leasing a car by CarBevy can help people who are considering leasing a car understand how the process works.
Regardless if people buy or lease a car, they can receive a dreadful house visit if they fail to keep up with their monthly payments. This visit might involve a van or pickup truck arriving outside, a couple of burly-looking gentleman get out of it and come to knock on your door. They’re the much-maligned repo men, here to repossess your car that you’ve been struggling to pay for this past several months.
When You Drive Off More Car Than You Can Handle
Why did the above situation happen? Why are 2.2 million vehicles in the US repossessed every year in the US, according to 2021 data from titleloanser.com? That comes to a staggering 226 cars repo’d every hour.
The federation of state Public Interest Research Groups (US PIRG) reported that 84.6 percent of newly purchased vehicles in America are financed, and 54.6 percent of used-car purchases are done so with finance. With so much borrowed money — $1.35 trillion by Q1 2020 according to Experian is owed to banks, credit unions, and others — it starts to become clear that a lot of people have been ignoring the cardinal rule of financing a new car: 20/4/10.
What is the 20/4/10 Rule?
This is a rule of thumb touted by many as the safest-possible way to play the car financing game. The idea is that you plan your car financing using the three numbers 20/4/10 in the following ways:
20 – Give a Deposit of At Least 20 Percent
In the first year owning a new car, it will lose almost 20 percent of its value. Amazingly, just under half of that percentage drops off as soon as you drive the thing off the lot. The bigger deposit you can put down, the less chance of you have of “going underwater” with your car loan.
To go “underwater” means that the amount you owe on the loan is greater than the amount the car is currently worth after depreciation. Putting at least 20 percent down is generally acknowledged as the most effective way of avoiding this trap. As we said above, the amount of depreciation in the first year is almost 20 percent — 19 percent in fact, according to Edmunds.com — so if you’ve deposited 20 percent at the start, and made 12 monthly payments in your first year, then you’ll be well out in front of the depreciation.
4 – Don’t Finance the Car for More than 4 Years
Longer periods for a car loan look attractive on the surface because while you’re paying longer, the individual payments are lower. It therefore feels like you are giving yourself less of a financial burden. Perhaps in the short term you are, but as you get the end of a 5-year loan or longer, the amount of interest you end up paying is much greater than those of a shorter loan period.
It stands to reason: the shorter your loan period, the less interest the bank makes but the steeper your monthly payments. Therefore, according to the 20/4/10 rule, a period of 4 years is a good compromise solution. It allows for affordable payments, but doesn’t protract interest payments any longer than is reasonable.
If you are able to manage a shorter financing period, such as 3 years, then it’s even better, but for most people 4 years is optimum.
10 – Total Payment Mustn’t Be More Than 10 Percent of Gross Income
The ‘10’ refers to 10 percent of your gross income, which is pay before taxes and other deductions. To be clear, we are not just referring to your car loan monthly payment here, but also to the interest and insurance. In other words, the amount you’re spending on owning and having the right to drive the car shouldn’t exceed that 10 percent.
The reason behind this is the generally unpredictable nature of life itself. What if you were to temporarily be out of work or received a cut in salary during hard times (like the COVID-19 pandemic)? Maintaining the payments only at 10 percent of your income means you never end up with a serious financial burden even during the most difficult and stringent times.
What Does 20/4/10 Mean for Car Purchasing?
Let’s imagine a scenario to see how the 20/4/10 rule would help someone get the right kind of car that would be affordable for them.
Scenario: Kyle’s First Car
In our scenario, let’s imagine Kyle, a young professional from San Diego earning a gross annual salary of $48,000, or $4,000 a month. He used to make use of public transport to get where he needed to be, but as of next month he is preparing to start a new position at a company located further away in the suburbs. There’s no bus route, all the employees who commute do so by car.
Kyle has saved up $5,500 to use as a deposit, and is interested in two cars. One of them is one of America’s best-selling sedans, the Honda Accord. The price of a brand-new one is $24,970. The other car is a BMW 3 Series, which he feels has that executive look he likes, but it starts at $41,250 for a core 330i model.
The question, then, is according to the 20/4/10 rule, which one should he buy? You have likely already determined that it obviously should be the Honda Accord. In one sense you’re right, but there’s a bit more to it even than that.
First, let’s apply the ’20,’ where we can see that his savings are enough to cover the 20 percent deposit on the new Honda Accord. For the BMW, he could only put down a 10 percent deposit. Let’s assume next that Kyle opts for a 4-year loan because he feels the payments will be more manageable. He’s sensible like that. Finally, we get to the crucial ‘10’ part. We know that Kyle’s monthly gross income is $4,000, so will 10 percent of that, just $400, cover payments on both cars?
Kyle chooses the base level Honda Accord from a Honda car dealership and looks at the final cost, which with the fees and extras is $25,965. His 20 percent deposit would therefore come to $5,193. No problem there. With an APR of 1.9%, spread over 4 years, his monthly repayments come to $450. That’s just slightly above the 10 percent, but it’s pretty close. When you add in an annual insurance rate on average for the Honda Accord totaling $1,604 ($133/month) that brings total payments to $583 per month.
Strictly speaking, even under the 20/4/10 rule Kyle can’t quite afford the Honda Accord. We needn’t even calculate the BMW rate, then. So, is Kyle doomed to walking? This is where we forgot one extra factor.
When the Rule Doesn’t Fit – Buy Used
It’s tempting to travel outside of the 20/4/10 rule, especially when it doesn’t seem like such a wild difference. In good times, you might be able to afford it, but this rule is designed to prevent drivers from falling into serious difficulty — perhaps meeting the repo men — if and when times get really tough.
At the same local car dealership that Kyle visited, there was a Honda Accord, 18 months old, already depreciated by 25 percent from the new value, and yet still quite close to new. That brings the selling price to $19,473. The 20 percent deposit would be just $3,900, and his total monthly payments would come to roughly $480, which is much closer to his 10 percent. It looks like Kyle has found a suitable car that meets his needs.
Criticism of the 20/4/10 Rule
Not everyone agrees with the rule, as it happens. The first thing people point out that if you are serious about buying a new car and you are worried about potential pitfalls in the future, then paying cash for it is the only way to go. This is tricky, however, since data has shown that many Americans don’t have more than several hundred dollars available in their account at any one time for superfluous buying.
The second criticism of the 20/4/10 rule is that too many people have no concept in their mind of either what they need or want. This makes taking an affordable path, even using the rule, a harder thing in reality than in theory. This combined with the unscrupulous actions of lenders and keen salespeople blinding buyers with “no money down” and “interest free for 12 months” makes for a bleak outlook in the long term.
Finally, another criticism levelled at the 20/4/10 rule is particularly aimed at the ’10.’ As we mentioned above, the 10 refers to 10 percent of gross income, not net income. Some experts point out that this is a foolish guideline because if you are going to use a percentage of income then the safest number to use is net income because it accounts for critical outgoings like state and federal taxes. In other words, it is a more accurate reflection of your real income and therefore what you can actually afford.
Conclusion: Does the 20/4/10 Rule Help?
Any expert will point out that if you use the rule smartly and correctly, then yes it will help you to avoid any potential financial albatross from being hung around your neck. If you apply the rule strictly, perhaps accounting for net income instead of gross income if you have any reason to be worried about your future circumstances, then it should see you right.
Where the rule falls down is not in its own logic, but rather in how people themselves apply it, if indeed they do at all. This is where services like CarBevy can come in handy. By nominating the price yourself to see if the new car dealerships accept, you can gain better control of the financials from the very beginning of the process.
Use the 20/4/10 rule from the very beginning, at whatever point it is that you have resolved to buy a car for whatever reason. Use it smartly and realistically and you should find yourself always in a solid and comfortable position when it comes to financing your next car purchase.