Cars are the most expensive item that we buy that goes down in value.
And we generally start buying them at a pretty young age.
So figuring out how to buy a car the right way is of the utmost importance to all of
our financial futures.
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So today I thought I would go through a rule of thumb that I've seen thrown around a lot
for buying a car.
It's called the 20, 4, 10 rule and in today's video, I'm going to talk about what the 20,
4, 10 rule is when it should be used, give my overall thoughts on the rule, and then
talk about some possible alternatives for saving up for a car.
Let's get started.
So what is the 20, 4, 10 rule?
Well as I said a moment ago it is a rule of thumb to help you try and figure out how much
you should be spending on a car purchase.
It basically goes like this, you must put at least 20% down on your car, similar to
how you would with a home, you must Finance the car for no more than 4 years, and you
must keep the total monthly vehicle expenses which include the principal and interest payments
as well as insurance (and some people also even include gas), under 10% of your gross
income.
So, for example, let's say you had a $60,000 a year household income.
This means that your monthly gross income is about $5,000.
If you were to follow the rule of thumb when looking to buy a new car you would, therefore,
need to keep your total monthly vehicle expenses under $500.
On the one hand, this is nice because it does limit you to a certain extent when buying
a new car.
It does force you to at least put something down on the loan and it does shorten the length
of the loan, at least in comparison to the average car loan which is between 5 and 6
years long.
This means that your monthly payments on the car are likely going to be a little bit higher
than for someone else buying the same car but having a longer loan period, so it makes
you a little less likely to buy a car that you can't truly afford because you see what
the payments are going to be.
Let's take a look at an example.
Let’s say that John took out a $25,000 car loan and didn’t follow the 20/4/10 rule,
meaning he didn’t put the 20% down on the car.
So he has a $25,000 loan charging him an interest rate of about 4.4%, which appears to be right
about average at the time I’m writing this script according to bankrate.com.
His loan term is 60 months and his monthly payment is about $465.
He pays nearly $2,900 in interest over the course of the 5-year loan, or a little under
$50 a month on average.
That’s all fine and good, but what if John had followed the 20/4/10 rule?
His loan would have been for $20,000 because he would’ve made a $5,000 downpayment and
the loan would’ve lasted 4 years instead of 5.
This means that assuming the interest rate was the same, he would have a monthly payment
of $455 (yeah, you heard me right, it’s actually lower than the previous example!)
and would pay about $1,850 in interest.
But it gets even better!
Because he gets out of debt a full year sooner, he may be able to take that 5th year (assuming
he doesn’t buy a new car) to start saving toward his next car purchase.
If he did that for the 5th year, putting $455 a month in the bank and assuming absolutely
no interest whatsoever, he would have $5,460 in his savings account just waiting for his
next car.
Which is more than enough to make the down payment he made for his current car.
So you can see that it makes a decent amount of difference.
And I think that using this rule is certainly better than using no rule at all.
So if you're in a situation where you just don't really have a guide to use for figuring
out how much you should be spending on your next car then certainly give this rule a look.
However, it doesn't sound like the best rule to be following, in my opinion, most of the
time.
Let me explain.
While it does limit the amount of time you are spending in debt with a car loan it doesn't
actually eliminate the need for a car loan in the first place.
Now if you're in a situation where you absolutely need to get a new car because your old one
is basically not running anymore and you don't have much time to plan out your next car purchase
because it has to happen very soon then, by all means, use this rule again it's better
than having no rule at all, but if you do have a little bit of time in between your
next car purchase then ideally what you would do is in just your current budget so that
you can start saving a little money to buy a decent short term used car in cash.
Normally, I like to buy cars from family members of mine who I know take good care of their
vehicles because that way I get a well-maintained car and they get to make some extra money.
I know that not everybody is in a situation where they can do that so you may just have
to go to a used dealer that you trust and get a car but think of the difference that
this makes.
Let's say you were going to follow the 20, 4, 10 rule like John did in the previous example.
We’ll even use the same numbers as before, meaning that John currently has $5,000 in
the bank ready to make a downpayment.
But, if you were to, instead of making that down payment, use that money to buy a $5,000
used car and thus eliminate the need to have a car payment at all, how much of a difference
would that make over the next four years (because remember the rule states you can only finance
a vehicle for up to four year)?
Just like John’s previous example where he had a four-year $20,000 loan charging him
a 4.4% interest rate, he would have a monthly payment of $455 a month.
And over the course of that loan, he would pay almost $1,850 and interest.
However, if he were to go and get the used car and not have a car payment he would be
able to save that $450 a month towards his next car purchase.
Meaning that every single year that he managed to keep that used car running his would be
able to put away $5,460 towards his next car.
Assuming no interest whatsoever.
If he had enough time to shop around and found, just for example say, a good used Toyota for
five grand that had maybe a hundred fifty thousand miles on it and took care of it he
might be able to get it to last two, three, maybe even the full four years depending on
how well it was taken care of beforehand.
And this isn't an ad for Toyota and they're not sponsoring the video it's just I know
that they are generally known to run pretty well for a fairly long time if you take care
of them.
But if the used-car managed to last for 2 years that means he would have roughly $11,000
in savings for his next car purchase.
If it lasted 3 years he would have roughly $16,400 and if it lasted the full 4 years
he would have roughly $21,900 for his next car purchase.
Depending on what kind of car he wanted to buy next that very well might be enough to
purchase it in cash.
And then he'll never have a car payment again and we know how much of a difference that
can make in your financial life based on my how much is that car payment really costing
you video that I did earlier on this channel.
Now obviously there are other variables that can come into play when making a car purchase
such as resale value and maintenance costs on a vehicle.
But if you’re looking at getting a new car, I’m assuming that you already have maintenance
costs for your current car.
Would the used car immediately have more monthly maintenance costs?
Maybe, it depends on what your current costs are and how good of shape the used car you’re
looking at is in.
But even if it is, I doubt it is going to be $400-$500 a month more in maintenance costs
than what you’re currently paying.
So you may not be able to put away the full $450 or whatever your own numbers come out
to be in your situation every single month, but you should still be able to get ahead.
And I know that some people just don’t like buying used, my dad was one of them.
So I do want to say that this isn’t a long-term thing, or at least it doesn’t have to be.
Again if you’re putting away roughly $450 a month, like in that last example and the
first used car lasts you for 2 years.
You take care of it while you have it and after 2 years you sell it for say $2,000.
You have saved roughly $11,000 in your two years of car ownership without a car payment.
Meaning that in addition to the cash from the sale of your car you have nearly $13,000
to spend on your next short-term used car.
Let’s say that you put it into something with a little more resale value, like a Toyota
Tacoma (again their not sponsoring this video, I’m just using it as an example since the
Tacoma's resale value is generally pretty good if it's taken care of).
You drive that for another 2 years and sell it for something like $8,000, which let’s
be honest is probably being a little conservative based on what I’m seeing on AutoTrader as
I’m writing this script.
Meaning that in addition to the $11,000 you again saved in the last 2 years, you have
nearly $19,000 to spend on your next car.
And depending on the car you want that may be about enough to get it in cash.
But that'll do it for me today once again if you enjoyed this video be sure to subscribe
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