No one can claim there’s only one “right” way to buy a car. There are just too many options. Some buyers choose to use dealer financing. Others take out a personal loan to buy a car. The “20 rule” is a guideline to measure affordability. The most common version of this is the 20/4/10 rule. It can be applied to new or used car purchases.
What is the 20/4/10 rule?
The 20/4/10 rule suggests car buyers put down 20% as a down payment, take out a loan with a four-year term (48 months), and make monthly payments of no more than 10% of their net monthly income. According to Kelley Blue Book, the average price of a new car at the end of 2023 was $48,247. Round that up to $50K to include taxes and other fees (roughly), and the numbers for a 20/4/10 purchase would look like this, assuming an average interest rate of 8.99%:
- Down Payment: $10,000
- Loan Term: 48 months
- Monthly Payments: $995.21
The 8.99% interest rate on the loan in the example above is the average new car loan interest rate for those with fair credit as stated by MarketWatch. For a buyer to afford a monthly payment of $995.21 under the 20/4/10 rule, their monthly net income would need to be $9,995. That’s in addition to coming up with the $10,000 down payment in cash or trade-in value.
A simple way to do this is to calculate 10% of your monthly income and take that number to the car dealership when negotiating a purchase. Conversations about auto purchases usually begin with discussing what the buyer can afford. Once they know, car salespeople have several tools they use to lower or raise monthly payments, including shopping your request to multiple lenders.
Why choose a four-year loan term?
Cars depreciate by 20% in their first year and roughly 15% per year every year after that for five years according to Progressive Insurance. Based on those numbers, at the end of a four-year loan term, when your $50,000 new car will be paid off, it will only be worth $24,565. You’ll be lucky to get $15,000 on a trade-in three years after that. Dealerships are more likely to offer $10,000.
The four-year mark is a good time to consider upgrading to a newer vehicle. It may be tempting to enjoy life without a monthly car payment for a while, but keep in mind that the condition of a car deteriorates with age. Buying a new car with a warranty could be more cost-effective than paying for expensive car repairs on a vehicle that’s losing value every time you drive it.
Buying a used car with the 20/4/10 rule
The numbers for buying a new car can be daunting. Used cars prices are typically lower than those of new vehicles, but prospective buyers should still apply the 20/4/10 rule to calculate exactly how much car they can afford.
Along with paying a lower price, another benefit to buying a used car is that you may not need dealer financing to afford one. Putting $5,000 down on a $25,000 vehicle and taking out a personal loan for $20,000 could be a better option. The monthly payments, depending on interest rate, may be more manageable if you’re making under $5,000 a month. A new car purchase can wait until you’re ready for it.
Sources:
https://www.woodhouselincoln.com/blog/2022/july/6/lincoln-financing-101-the-20-4-10-rule-of-car-buying.htm
https://www.capitalone.com/cars/learn/managing-your-money-wisely/why-the-2038-car-buying-rule-may-be-obsolete/1584
https://www.nerdwallet.com/article/loans/auto-loans/car-loan-calculator
https://www.kbb.com/car-news/average-new-car-price-sets-record/
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