What is the 20/4/10 Rule and Why Should You Use It?

The 20/4/10 rule is a tool used by car buyers to determine if a vehicle purchase is within their financial means. Its purpose is to assist in making financially responsible decisions and to prevent people from getting into a situation where they are living beyond their means. Every individual who is planning to make a vehicle purchase in the near future should be familiar with the 20/4/10 rule.

This rule is a good starting point to understanding how much car you can afford and which loan will work for you. It addresses the down payment, loan term, and total transportation expense threshold. In a nutshell, the 20/4/10 rule recommends that you make a down payment of at least 20%, have a loan term of no more than four years, and spend no more than 10% of your income on transportation expenses.

Make a Down Payment of 20% or More

According to the 20/4/10 rule it is recommended that you have a down payment of at least 20%. Making a substantial down payment shows that you are a serious buyer who has their finances in order and that indicates less risk for the lender. Being a low risk borrower gives you access to better deals on your loan and with that comes paying less interest and keeping more money in your pocket.

Buying a new vehicle can leave you in a state where you have negative equity in the car you just purchased. This means that you owe more on your loan than the vehicle is actually worth. You will automatically be in this situation if your down payment doesn’t even cover the cost of borrowing represented by the interest and fees.

The biggest culprit contributing to negative equity is the rapid depreciation of the car. After the first year you can expect your vehicle to be worth around 20% less than when you bought it and half of that depreciation happens in the first month after purchase. Over the following four years the vehicle will continue to lose value at a rate of about 15% per year.

Having negative equity limits your options if you ever need to sell your vehicle. It can be particularly difficult if something were to happen and your car was written off. You may find yourself in a position where you have to continue paying for a loan even though you no longer have the vehicle.

Making a down payment of at least 20% puts you in a stronger position and protects you from negative equity. It gives you a head start on paying off your loan and ensures that you own a generous portion of the vehicle when you drive it off the lot.

Loan Term of No More Than Four Years

The lower monthly payments make a longer loan term tempting but it comes at a cost. While your monthly bill decreases, extending the term of your loan means you will be paying it off for a longer period of time and usually at a higher rate of interest. This means that you will end up paying more for your vehicle.

The amount of time that it takes you to build equity in the vehicle will also be negatively impacted by an extended term. The smaller monthly payments mean that it will take you longer to break even. You will be in a negative equity situation for a longer period of time and this represents a higher risk in the eyes of the lender while placing you in an unstable financial position.

The 20/4/10 rule identifies a 48 month term as the optimal amount of time to repay a car loan. Paying off your debt within four years will allow you to break even much faster. You may even be able to skip negative equity altogether if a 4 year term is combined with a decent down payment.

Keep Transportation Costs Under 10%

The final part of the 20/4/10 rule is related to vehicle affordability in terms of your budget. It is advised that your transportation costs should account for no more than 10% of your net income. This includes all of the costs associated with owning a vehicle including fuel, maintenance, insurance, and your monthly loan payments.

Keeping your transportation costs under 10% protects you from the risks associated with owning a vehicle. This component of the 20/4/10 rule often affects the other two parts. Allowing transportation costs to creep higher can make it a struggle to save up 20% for a down payment and a 4 year term could make your monthly payments unmanageable.

Tips to Stay Within the 20/4/10 Rule

The 20/4/10 rule aims to assist car buyers with determining what they can comfortably afford. While it is only a guideline and might not be ideal for every situation, it is prudent to aim for these financial benchmarks whenever feasible. Sometimes making small changes or adjusting goals can help you reach your target.

It may not be what most of us want to hear but often the best solution is to shop for a less expensive vehicle. Prioritize needs over wants and determine what you can realistically do without. Buying a used vehicle that is 6 to 7 years old should still get you to where you want to go but at a fraction of the price.

If you can’t afford the car you want, be open to keeping your current vehicle a little longer. It will give you some time to save for that down payment. You can also use this time to work on your credit score so that when it comes time to buy, you’ll be eligible for the best rates.

One of the easiest things you can do is shop around for financing. Not all lenders are created equal and each has their own set of criteria when it comes to interest rates, services, and fees. Get a head start on comparison shopping at myAutoloan where you can quickly and easily compare quotes with no pressure to buy.