Shopping for a New Car? Use the 20/4/10 Rule

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Updated on Sunday, May 31, 2020

Unsure of how much you can afford to spend when buying a new car? Consider the 20/4/10 rule, which suggests that you should aim to put down at least 20% of the car’s purchase price, finance it for no longer than four years and keep your total transportation costs under 10% of your monthly income.

The average monthly car payment in the U.S. isn’t cheap: $550 for a new car and $393 for used with an average loan term of nearly six years. That’s a lot of money and a long time to pay. It also doesn’t include the costs of fueling, insuring and maintaining that car. By calculating your total budget before you set out shopping — and sticking to it — you’re less likely to fall in love with a vehicle that you can’t afford.

Rule #1: Put down at least 20%

A vehicle is not an investment, no matter what the car salesperson says. It’s a depreciating asset; it loses value over time. The experts at Edmunds estimate a new vehicle loses nearly a quarter of its value in its first year of use and 60% after five years. If you borrow $30,000 for a new car today, it’s going to be worth less tomorrow, but you’ll still owe the original amount.

Making a down payment of at least 20% greatly reduces that risk. Plus, the larger the down payment, the lower the total cost of your loan. Of course, it’s easier said than done when average new car prices are around $38,000, which would mean a 20% down payment of $7,600. Here’s a closer look at the benefits and drawbacks of a large down payment.

Pros

  • Lower chance of becoming underwater on your loan. Cars, especially new cars, may depreciate faster than many people can pay off their car loans. If you owe more on your car loan than your car is worth, then the car loan is underwater and you might struggle to make up that difference when you want to trade in or sell.
  • Save on GAP. In the case of a total loss in a car accident, auto insurance companies pay what the car is worth, not what you owe. Unless you bought a guaranteed asset protection or guaranteed auto protection (GAP) waiver or GAP insurance, which promises to make up the difference. But it can be expensive. By putting 20% down, assuring you owe less than the car’s value, you won’t have to worry about buying GAP to the tune of hundreds of dollars.
  • Lower APRs. A lower loan-to-value (LTV) ratio means less risk for the lender and potentially lower rates for you.

Cons

  • Higher APRs. Let us explain. If your 20% down payment drops your total loan amount to a lower tier — say, $14,000 instead of $15,000 — you may lose out on the lowest APR possible. This isn’t the case with all lenders, but it is possible. You could always borrow more for the lower rate and then immediately put your saved down payment toward the loan principal.
  • Limited choices. A 20% down payment will probably restrict your choice of vehicles — the more expensive the car, the higher the down payment. Dream cars may be off-limits.

If you cannot make a 20% down payment, aim for at least 10%, which should cover any taxes and fees. It also means your LTV ratio shouldn’t be over 100%. By not borrowing more than what the car is worth, you could attain a better APR and limit your risk of being underwater.

Rule #2: Finance the vehicle for no more than 4 years

If you borrow less, your loan term will likely be shorter. And the shorter it is, the less you’ll pay in interest over time. Dealers will try to sell you on a higher-priced car with a lower monthly car payment, but don’t be swayed — chances are the payment is so low because the term of your loan is so long.

You can use a car loan calculator to see this rule at work. If you borrow $25,000 to purchase a car at a 4% APR, you would save $1,066 by signing for a four-year term rather than a six-year term. Yes, that shorter-term loan comes with a higher monthly payment, but you are saving more over the long run.

Turn the conversation around. Car salespeople almost always want to talk about your monthly car payment. They can meet payment expectations and still increase what you pay in total simply by lengthening the loan. If you focus on totals instead — how long you’re borrowing in total, how much the car costs in total — rather than payments, you’re much more likely to negotiate a good deal.

If you can’t afford the monthly payment required to pay off the loan in four years or fewer, it’s probably outside of your budget.

Rule #3: Keep your total transportation costs under 10% of your monthly income

This last part is where it gets easy to overspend. According to this rule, you should keep your total transportation costs — car payment, insurance, gas and maintenance — under 10% of your monthly income.

The simplest way to calculate this is off your monthly gross income. So, if you earn $5,000 per month, your total transportation costs shouldn’t cost more than $500. Yet if you want to be more conservative with your finances, you could calculate this off your net income.

20/4/10 Rule
Gross Monthly Income Example
20/4/10 Rule
Net Monthly Income Example
Gross income$5,000Gross income$5,000
(Taxes and deductions not considered.)Federal and state taxes$1,500
Deductions for health
insurance and retirement
$180
Net income$3,320
10% of gross income$50010% of net income$332
Average cost of car insurance$78Average cost of car insurance$78
Estimated cost of fuel$50Estimated cost of fuel$50
Estimated cost of maintenance $10Estimated cost of maintenance $10
Car payment$362Car payment$194

Though the figures above are estimates and may be lower or higher for you, there’s a huge difference depending on how you calculate the 10%. How you decide to do this is up to you. If your total transportation costs land somewhere between 10% of your gross income and 10% of your net income, then you’re probably doing well. The idea is to leave room for the unexpected — with transportation costs limited to 10% of your budget, it would be easier to weather a job loss or other unpleasant financial surprise.

If you cannot limit your transportation costs to under 10%, try to keep them as low as possible and definitely keep them under 20%.

How to save on the cost of a new car

Try these tips to keep your overall transportation costs low.

Get preapproved for financing

Avoid financing your vehicle through the dealer, and get preapproved for financing at a lower rate before you show up at a dealership. Financing your auto loan at a lower rate can reduce your monthly loan payment. If you walk onto the lot with a preapproved auto loan rate from a bank or credit union, you can use that as leverage for negotiation.

If you let the dealer find the loan for you instead, you’ll lose negotiating power, and there won’t be a way for you to tell if the dealer’s loan rate is the best offer you can get. Avoid making these other common mistakes when searching for a car loan.

Buy used

Used car sales outstrip new vehicles. When you buy used or certified pre-owned vehicles, you avoid financing a larger balance, and could even skip financing altogether if you’ve got enough cash on hand. If you buy used, avoid engine trouble by having the vehicle inspected by an independent mechanic before you sign off. You can use a resource like Car Talk to find a mechanic in your area.

Buy a car that holds its value

Depreciation is a car owner’s largest transportation expense during the first five years of ownership — more than fuel, maintenance and even insurance.

A car that holds value well will depreciate less over time compared with the average vehicle, so you may not lose out on as much in depreciation costs if you sell the vehicle after a few years. Carmakers like Honda and Porsche are known for building vehicles that hold their value well over time, according to Edmunds and Kelley Blue Book.

Look for gas savings

Gas can be less of a painful, unavoidable expense. You can make a few changes to your fueling habits like filling up before you hit “E” or signing up for a gas rewards credit card. You could also cut down transportation costs by cutting back how often you drive or by carpooling some days to school or work.

Comparison shop

Don’t get lazy with must-haves like maintenance and insurance for your vehicle. Comparison shopping is the best way to save on costs like these that may differ from provider to provider. Insurance companies have made it easier to compare quotes with online comparison portals, like this one from ValuePenguin. You could also try going through your bank or credit union for discounted rates with select companies.

Don’t just take the first estimate you get for a repair. Mechanics are known to pad the bill with unnecessary repairs from time to time. After you figure out what’s wrong with your vehicle, get an estimate from a few different mechanics in your area. That way you’ll make sure you’re getting the best value before paying for maintenance and repairs.

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