What Is the 20/4/10 Rule for Car Buying?

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Article QuickTakes:

• What is the 20/4/10 rule?
• How does it work?
• Putting it into practice
• Potential drawbacks to the 20/4/10 rule
• When to use or avoid the rule
• Strategies to stay within your 20/4/10 budget

What is the 20/4/10 Rule?

This rule suggests you can afford a car if you can meet the following three requirements:

• You can make a down payment of 20% or more when purchasing the car
• You can take out a car loan with a term of four years or less
• You can have your total transportation costs—not just your car loan—be less than 10% of your monthly income

In theory, this rule can help you in multiple ways. First, it makes sure you can afford a down payment on the car. This is important because new cars begin to depreciate when you drive them off the lot. Without a decent down payment, you may immediately end up upside down on your car loan.

A four-year car loan can help you limit the interest you pay because you'd pay off the loan relatively quickly. Finally, keeping your total transportation costs to less than 10% of your monthly income can help ensure a car doesn't dominate your budget and leaves room for other expenses.

Remember this is only a guideline that can inform your decision. It's impossible to make it fit every person's situation. You may decide to spend more money on a car because it's something you truly value or because you must have a reliable vehicle to keep a job. Others may decide to spend less on a car because they'd rather allocate their money elsewhere.

How the 20/4/10 Rule Works

Using this rule in practice requires some thought but isn't difficult once you understand the process.

To start, you need to know the purchase price of a vehicle. This allows you to calculate how much a 20% down payment would be. Next, you can figure out how much you'd need to finance and get an estimated interest rate. Use this information to come up with the monthly loan payment, including interest costs.

Then, calculate the total transportation costs of a vehicle for a month as a percentage of your income. This is a bit trickier because it includes costs such as insurance, fuel, maintenance, and more. You can use a total cost of ownership calculator to estimate some of these expenses. You don't need to include any depreciation costs, but you do need to include the car loan payment.

Finally, divide the total cost of the vehicle by your monthly income. The 20/4/10 rule doesn't state if this should be your net income (after taxes and deductions) or your gross income (before taxes and deductions). You can use your best judgment or what fits your needs best.

Putting the Rule Into Practice

Here's a hypothetical example: A person decides they want a $30,000 sedan. They calculate a 20% down payment would be $6,000. That leaves a balance of $24,000 to finance with a four-year loan at a 4.37% interest rate. This results in a monthly payment of about $546.

Next, they calculate other transportation costs. In this example, they may estimate monthly costs as follows:

• Insurance: $57
• Maintenance: $46
• Taxes and fees: $25
• Fuel: $129
• Loan payment: $546

Based on this estimated information, the total cost of ownership per month would average out to $803 for this vehicle. According to the 20/4/10 rule, the individual's monthly income would need to be $8,030 or higher to afford this payment.

Potential Drawbacks to the 20/4/10 Rule

It's important to note that this rule is far from perfect. Unfortunately, it's a longstanding rule that fails to consider the lack of significant wage growth compared to high inflation in the new car market. The U.S. household median income for 2010 was $49,276, which increased to $67,521 in 2020. This represents an increase of 37%. At the same time, the average price of a new car rose from $24,296 in 2010 to $40,107 at the end of 2020. That's an increase of almost 61%.

Rules like this don't typically account for all situations, either. A car enthusiast may be willing to spend 20% of their income on a car and reduce their spending on housing by 10% of their income to offset that. Similarly, a family that would rather have a more expensive home may decide to buy a used car and only use 5% of their income on a car to put an extra 5% toward housing.

When to Use or Avoid the Rule

In general, this rule can help prevent you from overextending yourself when purchasing a car. For financially established individuals, it may make sense to consult this rule for a reasonability check before buying a car. Meanwhile, people on a limited income or those just getting started on their journey into adulthood may find this rule unreasonable. They may need to make adjustments—either up or down—to find a car that fits their needs and budget.

Strategies to Stay Within Your 20/4/10 Budget

If you want to stick to this rule, here are a few ideas that may help:

• Make a larger down payment
• Buy a base model rather than an upgraded model
• Consider last year's leftover new car inventory
• Purchase a used car instead of a new car
• Keep your current car longer and set aside what would be your monthly payment until you can save more for a better vehicle

This rule may make sense in your situation, or may be an outdated guideline that hasn't kept up with your current reality. Considering the rule before making a purchase can help give you a quick reality check.

Bottom Line

The key is realizing only you know what you can afford. As long as your car purchase fits within your budget, you can use this rule of thumb as a guideline rather than a strict rule you must follow.