FINANCIAL ADVICE: Buying a car using the 20-4-10 rule

February 14, 2023

IT’S THAT time of year, when we start thinking about changing our cars, but I think knowing how much you can afford, is the first step you need to know before you trade in your old car, for a new or newer one.

And in this regard, there’s a great rule of thumb formulae which can help us with this, and it’s known as the 20-4-10 rule.

It puts parameters around the three car buying factors that affect your monthly budget, and its primary goal is to keep you from overextending yourself, and here’s how it works and where the numbers come from.

n Have a deposit of at least 20% of the purchase price

n Finance the car for no more than four years

n And keep your total monthly expenses (not just your car repayments – insurance, maintenance, and tax costs as well) under 10% of your gross monthly income

Having at least 20% of the cost of the car helps keep your repayments manageable.

Keeping the term of your loan at four years lessens the amount of interest you repay to the finance house.

And keeping this particular monthly expense at less than 10% of your monthly income gives you a little more flexibility, if, you're hit with an unexpected bill or you lost your job.

As with all rule of thumb rules, they aren’t a one size fits all solution because they don’t and can’t account for your individual situation, but they’re not bad either.

Because they help you put some figures together, which with this particular rule, might help with the car buying decisions, you might be thinking of making.

How you can apply the 20-4-10 Rule to You

First, know what your gross annual income is.

Multiply it by 10% and divide by 12 this is the amount you can apply each month towards the cost of owning a car.

Deduct 10% to account and pay for other monthly costs.

Divide the amount left over by 0.024 and this will give you the amount you should borrow (I’m basin this number on an interest rate of 7.5% over a four year term)

Divide the answer to point four by .80 and that’s the maximum amount you should pay for a car using a 20% down payment.

Applying the above to an annual income of €60,000.

1. €60,000

2. €500

3. €50

4. €450/0.024 = €18,750

5. €23,438

I come across people all the time who put a lot of time and effort into making savings to their weekly shopping, the amount they spend on clothes, nights out etc. but all their good efforts can be wiped out when they make big purchases like buying a car, simply because they take on more debt than they can afford.

Last year, I came across an individual who borrowed €30,000 to purchase a car and had monthly loan repayments of €720. After only a few months, he’s already beginning to feel the pinch.

Had he applied the 20-4-10 rule, he wouldn’t have bought a car costing more than €18,000 and would have limited his borrowings to c. €14,500. Had he followed this rule, his monthly repayments would have been €350 which would have been much more manageable than €720.

I like to remind people lest they forget that cars are ordinarily a depreciating asset. And yes in the past couple of years they have held their value but that’s not always going to be the case. And while we need them to get around, the type of car, and type of loan, and the total cost we pay for them doesn’t mean we should get carried away either, regardless of the amount a bank is willing to lend to us.

And for those of you who are buying a car for the first time, there are other monthly outgoings you have to factor into the running cost, other than the loan repayment, as a daughter of mine has recently found out i.e. tax, insurance, maintenance, parking, tolls etc.

So you need to be cognisant of what they are, and how much they will cost, which is why I think the 10% part of this rule, is good, because it keeps your total car monthly outlay in check with your monthly income.

Here’s another piece of advice worth considering.

Just because a car loan is finishing, doesn’t mean that’s the trigger for you to change your car, especially if you don’t have to.

You see, when you finish paying off a car loan, it’s only then when the real savings start to kick in.

When the loan comes to an end, keep making that monthly repayment as before, just re-direct it, into a savings account instead.

And then, in two, or three-years’ time, you might have enough cash along with your trade in value, to pay for a car outright in cash, and even if you don’t, at least the amount you have to borrow is going down rather than up.

Let me put some numbers together to show you this.

If your car repayment previously was, say, €350, and you kept the car for another two years after the loan was repaid, and saved that €350 every month, you would have saved €8,400. And, if you kept your car in good shape, and it was worth say €7,000, you can then purchase a car, debt free, costing €15,400 or borrow much less if it cost more.

I’ll leave you with some more tips that along with the 20-4-10 rule will hopefully prevent you in the future from driving a car you can’t afford, and they are:

n Let me repeat myself - the real savings with the ownership of a car, are when you have no more monthly repayments, and once the loan is repaid, continue making those repayments into a savings account which can be used towards your next purchase.

n Take care of the car you have, so you don’t have to change it any sooner that needs be.

n Don’t prioritize how a car looks over anything else. What should be at the top of your list is a car that is reliable, has a good reputation, won’t break down frequently, and one you’ll still be able to drive in 10 years, if, you wanted to.

Back in 1997, when the now world’s richest man, Jeff Bezos, was worth c. $12 billion, he changed his car and bought a Honda Accord. When he was asked why the modest purchase, his response was, ‘it’s a perfectly good car.’

n Don’t try to keep up with the Joneses - if they decide to upgrade theirs, the chances are good, they have very big monthly repayments, something you really don’t want to have for something that could be stationary 23 hours of the day.

n Don’t break your budget. Set a realistic number and don’t go over it. You don’t want to have to make sacrifices in any other area of your finances because your car loan repayment is too much.

n And remember a car is not an investment. They can cost a lot of money and they do largely become much less valuable over time.

Liam Croke is MD of Harmonics Financial Ltd, based in Plassey. He can be contacted at [email protected] or www.harmonics.ie

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