You are in the market for a new car, but how much should you spend? The 20/4/10 Rule of Car Buying states to put 20% down payment on the vehicle, take out a 4 year loan, and have the loan payments be no more than 10% of your monthly earnings. Following this rule will have you looking at cars well within your budget range.
Since overspending on vehicles is a common misstep of many people trying to unfukt their finances, everyone should know of and follow a car buying guideline like the 20/4/10 rule.
What is the 20/4/10 Rule of Car Buying?
The 20/4/10 rule of car buying sets parameters for a car purchase to prevent you from overspending.
The rule states you should:
- Put at least 20% down payment on the vehicle
- Take out a max 4 year loan, and
- Have the loan payments & other costs be at most 10% of your monthly income
Each of these 3 pieces play a part in the strategy to help to keep you within budget when buying a car.
20% Down Payment Keeps Overall Car Purchase Price Reasonable
You walk into a dealership and see all the sweet new, shiny vehicles there. You start talking to a salesman and he is upselling you on cars with extras you never thought you needed. Suddenly that modest car you had in mind seems like a junker by comparison.
Sure you live in a warm climate, but some mornings it is like 60 degrees out, heated seats would be nice. Especially after a workout, it would be relaxing on your back.
Or maybe you live up North, but those 2 months a year you can you use the sunroof would pay for itself right?
Next thing you know you are spending way more than you planned.
The 20% down payment part of the 20/4/10 rule helps to keep your purchase price in check. If you only have $5,000 to put down on a car, you can’t get a car over $25,000. If you have $3,000 you are keeping your car purchase price below $15,000.
Suddenly, that fully upgraded car with the custom trim feels more expensive as you would need to drop 20% of the price today.
Did the sales guy talk you into looking at that $50,000 car? Well paying $625 a month for 8 years doesn’t seem like much since you are spreading out the pain. Putting 0% down payment and driving the car off the lot with an 8 year loan is painless today, but max pain for the future you. However, paying $10k today (20% of $50k) makes the overspending on a car feel more real since it is immediate.
Speaking about loan length…
4 Year Max Auto Loan Length Lowers Interest Expense
Car loans generally are 3 to 8 years in length. The longer your loan length, the more interest you pay overtime. For example, if you take out a $20,000 car loan at 4.5% APR and pay the standard payments each period you would pay:
| Loan Length | Monthly Payment | Total Principal Paid | Total Interest Paid | Total Cost |
|---|---|---|---|---|
| 3 Year (36 Months) | $595 | $20,000 | $1,418 | $21,418 |
| 4 Year (48 Months) | $455 | $20,000 | $1,891 | $21,891 |
| 5 Year (60 Months) | $373 | $20,000 | $2,372 | $22,372 |
| 6 Year (72 Months) | $318 | $20,000 | $2,859 | $22,859 |
| 7 Year (84 Months) | $278 | $20,000 | $3,352 | $23,352 |
| 8 Year (96 Months) | $248 | $20,000 | $3,853 | $23,853 |
The illustrative example above shows that taking an 8-year loan over a 4-year loan decreases your monthly payment by almost half ($248 vs $455). However, you pay over double the interest on the 8-year loan as opposed to the 4-year loan ($3,853 vs $1,891). That is an extra $2,000 in interest expense on a $20,000 car, or an additional 10% of the ENTIRE car purchase cost.
Suddenly that lower monthly payment looks expensive when seeing the 10% extra you are paying for the car.
[Professor B.T. Effer Note – We used a flat 4.5% APR for all the loans above, but in real life the longer the loan the higher the APR goes. If your 4-year loan has a 4.5% APR, your 8-year loan may be 5.0% or 5.5% or more.
This means in real life, you’ll pay even MORE extra interest than shown in the table above. So it is even more painful taking longer loans.]
A 4 year (48 month) max loan length in the 20/4/10 rule does 2 things for you:
- It significantly decreases the interest you pay over the life of the loan
- It increases your monthly payment vs. longer loans which is important as you look at your monthly payment in your budget
- Don’t worry, the ‘increased’ monthly payment is because you are paying off the loan principal faster
You can go even shorter on loan length and pay less in interest and a higher monthly payment. But you want to make sure you aren’t allocating too much of your budget to car loan payments, which brings us to the 10% monthly payment part of the 20/4/10 rule.
10% of Your Monthly Income is the Most Your TOTAL Monthly Car Payments Should Be
You don’t want to tie up all your monthly income paying off your car loan. It will put a strain on your investing, it will make you less able to handle unexpected costs, and overall you’ll be less financially resilient.
The 20/4/10 rule states that the TOTAL car & transportation expense should be 10% of your AFTER-tax monthly earnings.
If you make $60,000 a year, you don’t take $5,000 a month of income as a starting point ($60k / 12 months = $5k a month).
Taking 10% of $5k would give you a $500 monthly car loan payment, but that is way more than the rule recommends. You need to make a lot of adjustments, and we will walk through an example.
Example: 10% Cap on Total Transportation Costs
Assuming you make $60k a year, pay 20% tax rate, and the insurance cost of $100 a month. You would only have $200-300 in car loan payments, not $500 as calculated incorrectly above.
- $60,000 x (1 – 0.2) = $48,000 after-tax annual salary
- $48,000 / 12 months = $4,000 a month of earnings
- $4,000 x 10% = $400 max monthly spending on total transportation costs
- $400 – $100 insurance – Gas & taxes & maintenance = $200-$300 of budget on an auto loan
- Note – we don’t estimate your gas, taxes, and maintenance above, that will be very individualized depending on where you live and how much you drive
At a 4.5% auto-loan rate that lets you buy $9,000 – $13,000 car depending on what you assume for gas, taxes, and maintenance costs. This involves a lot of math, if you want a simpler calculation you can use the modified 20/4/5 rule.
20/4/5 Rule As a Simplification
We think an improvement is to just use what we will call “the 20/4/5 Rule of Car Buying”. If you don’t care to do all the math above, just take 5% of your gross monthly income and use it as an approximation.
Same numbers as above and using $60k salary for $5k a month gross earnings. Take 5% of $5k to get a $250 limit on your auto loan. This puts you right in the middle of the range we got above in the longer calculation. Therefore, using 5% is a good enough approximation to avoid doing all the extra steps. You will get a number around the auto loan payment you need.
How Most People Car Shop (Wrong Way)
Most people car shop in the reverse order of what we recommend above, if they have a plan at all that is.
They have a number they can ‘afford’ in car monthly car payments and then go purchase the most car they can to fit that number. Assume someone has around $450 a month they can spend on car payments. They will go and buy the most car with the least down payment and longest loan term possible.
This allows you to purchase a much more expensive car, sure, but costs you in the long run.
In the previous table we showed that a $20,000 car loan at 4.5% APR and a 4-year loan results in $455 a month car payments. If you start with $450 and see how much car you can buy, you wind up with a $36,500 car at an 8-year loan with 4.5% APR.
| Monthly Payment | Total Principal Paid | Total Interest Paid | Total Payment | |
|---|---|---|---|---|
| $20,000 Car & 4-Year Loan | $455 | $20,000 | $1,891 | $21,891 |
| $36,500 Car & 8-Year Loan | $453 | $36,500 | $7,031 | $43,531 |
| Difference | $2 | $16,500 | $5,140 | $21,640 |
Even though your monthly payments are the same, if you purchase a $36,500 car you wind up paying nearly double the cost over the lifetime of the car vs a $20,000 car using the correct calculation ($43,531 vs $21,891). This is how people on a budget wind up with more car than they should.
Frequently Asked Questions on 20/4/10 Car Buying Rule
The 20/4/10 Rule of Car Buying states that when buying a new car, you should pay at least a 20% down payment, take out at most a 4 year loan, and have the monthly auto payments be a max of 10% of your monthly earnings.
* 20% Down Payment
*4 year max auto loan (48 months)
*10% max of your earnings to service the loan
The 20/4/10 rule is a guideline for the most to spend on a car. However overspending on a vehicle is one of the most common missteps people do when working towards fixing their finances.
Yes. You are supposed to use 10% of your after-tax monthly earnings to cover ALL your transportation costs including: Auto loan payment, insurance, taxes, maintenance/repairs, and gas. That involves a lot of math and guessing.
A reasonable approximation is to use the 20/4/5 rule where you just take 5% of your gross (pre-tax) monthly income. You get to a similar auto loan limit with significantly less math.
The Final Word on 20/4/10 Car Buying Rule
You now have all the information needed to go and make a reasonable car purchase within your budget. Next time you buy a car, make sure to:
- Put 20% down payment on the vehicle
- Keep your loan under 4 years
- Ensure your monthly total car payments are less than 10% or your after-tax monthly income
- Or that your car loan payment is less than 5% of your gross (pre-tax) monthly income
Follow the 20/4/10 or 20/4/5 rule to car buying and you will be well on your way to unfukting your finances and building wealth.
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