How Much Should you Spend on a Car? Check this 3-Point Rule

by | Dec 6, 2019

According to the 20/4/10 rule, when buying a car, you should make a 20 percent down payment, stick to a loan term of four years or less, and spend no more than 10 percent of your gross income on total vehicle costs. That includes car payment, insurance, gas, registration, maintenance, etc.

The 20/4/10 rule is traditional guidance on prudent budgeting when it comes to vehicle purchases. It offers a ceiling for what you should spend, based on your income. Obviously, spending less is a great idea if you’d rather have more money available for other things. Cars are depreciating assets – they lose value over time – so spending more than is really necessary on a car is never a good investment from a financial perspective. 

Of course, life is complicated. It’s not always possible to follow rules like the 20/4/10 guidance above. Some people have more debt to worry about; others have less. Some people live in places with better public transportation and can hold off longer on buying a vehicle. For other people, having a car is crucial to making a living. Our emotions often get involved with big-ticket purchases like autos, too. 

So let’s take a closer look at what’s behind the 20/4/10 rule. Even if you can’t or choose not to follow this guidance exactly, understanding where it comes from can help you make the best possible financial decisions for your situation when it‘s time for you to buy a car.


Why aim for a 20% down payment?

A down payment of at least 20 percent is considered prudent for a new car purchase. A minimum of 10 percent is considered a healthy down payment for a used car. 

What accounts for the difference? New cars depreciate rapidly in their first year, typically losing around 20 percent of their value. Making a 20 percent down payment when you buy a new car means you’re basically paying upfront for the value your car will lose by the end of the year. 

You never want to be “upside down” on your car – you don’t want to owe more on the car than it is worth. In this situation, which is also referred to as having “negative equity,” you couldn’t pay off your car loan if you sold the vehicle. Then you’d have no car but still be in debt. That’s a terrible situation to be in, and keeping your down payment at 20% or above (for a new car) makes this scenario less likely.

Because a car loses value fastest during its first year, used cars depreciate slower than new ones. This is why a 10 percent down payment is considered acceptable for a used vehicle purchase. That amount will likely still keep you from ever owing more than the car is worth. If putting 20 percent down on a car seems high for your budget, just stick with the 10 percent figure and shop for a used vehicle instead. You’ll still be in good financial shape. 

If you are on a tight budget, you should be focusing on used cars anyway. The rapid loss of a car’s value in its first year is something budget-minded car buyers should use to their advantage. Much of a new car’s value stems from its status as “new.” American car culture places a lot of importance on having the latest model and the status symbol of a new car, aided by carmakers’ advertising campaigns. 

But you can choose to value your own financial freedom over those superficial aspects of the car market, and dodge the bullet of a pricey vehicle you can’t really afford. If what you need is reliable transportation at minimum cost, there are plenty of used cars that will fit the bill. A vehicle that’s a couple of years old with modest mileage and a good maintenance record should still operate reliably and carry low maintenance costs, and you can feel financially responsible paying a 10 percent rather than 20 percent down payment. You’ll save money on car insurance, too!

Of course, the higher the down payment you make, the lower the amount of interest you’ll pay over the life of the loan, since you’ll be borrowing less of the purchase price. You’ll likely qualify for a lower interest rate, too. And your monthly payment will be lower for the same loan term.

If you are in a position to save money for a car without borrowing at all, that’s the best choice, since that reduces your interest payments to zero. 

Whatever your financial circumstances and car needs (saving up for a dream car, or just trying to squeeze something with four wheels into your budget that will get you to and from work reliably), keep in mind that the 20 percent rule, like any rule, won’t apply to everyone. Buying a pre-owned car and putting 10 percent down is probably a better budget move. If you can’t afford that, just try to scrape together as much as you can. Any down payment is better than none, and bigger is always better. 


Why aim for a 4-year loan term?

The shorter the loan term the less interest you’ll end up paying, reducing the overall cost of the car. 

Paying off your car means freedom from monthly payments. And if your car is still relatively new when you’ve finished paying it off, you get to enjoy the sweet spot of low maintenance costs and no monthly car payment for a period of time. (This is a great time to start making monthly savings account contributions toward your next car down payment.)

But standard loan terms for cars have been creeping up over the years. Financial gurus these days are decrying the recent move to six-year and even seven-year car loans because of the huge amount of additional interest the buyer pays. Six-year loans are the most common, with seven-year loans the runner up.

That’s in contrast with the previous standard five-year loan term from about a decade ago. Go back farther and you’ll find concerned commentators fretting in this 1986 Washington Post article that “The age of the 20-percent-down, 36-month, fixed-rate loan is over.”

Here’s why loan terms matter so much to financial experts. A car with a $20,000 price tag, purchased with a $2,000 down payment and identical sales tax, interest rate, and fees can end up costing:

  • A total of $23,563 with a four-year loan term and monthly payments of $449
  • A total of $24,036 with a five-year loan and monthly payments of $367 
  • A total of $24,515 with a six-year loan term and monthly payments of $313
  • A total of $25,302 with a seven-year loan term and monthly payments of $274

In other words, you’ll pay about $3,563 in interest for a car with a $20k price tag with this four-year financing option. If you stretched the loan out to seven years, you’ll pay $5,302 in interest. 

To find out how much a loan term impacts the overall cost of a car and the amount of interest you’ll pay, use this car affordability calculator

Don’t let the lower monthly payments of longer loan terms tempt you — you’ll end up paying so much more in interest. Even if you can’t do it in the advised four years according to the 20/4/10 rule, paying off your car as quickly as you can is the best way to keep your finances healthy. 


Why try to limit car costs to 10% of your gross income?

This figure forces you to look at the total monthly cost of car ownership in relation to your overall budget. You should add together estimated fuel expenses and maintenance costs, insurance, registration and license fees, parking costs and the monthly loan payment. 

If you hit more than 10% of your income, aim for a more modest vehicle. This means if you make $35K per year, your total auto-related expenses shouldn’t exceed $350 per month. 

Other guidelines offer different guidance on how monthly car expenses should compare with your monthly income. One rule uses net income as the reference (your take-home pay after taxes and other deductions) and allows total vehicle-related expenses to hit as much as 22 percent of that figure. However, the latter model assumes the car buyer’s only other debt is for a mortgage. 

If you have other debts, like credit card balances, student loans, etc., consider the 36 percent rule, which holds that you should not spend more than 36 percent of your gross income on debt repayment. (For purposes of this rule, housing costs count as debt, even if you rent rather than own a home with a mortgage.)

Everyone’s financial situation is different, of course. The point of all of these rules is to get you to think about the maximum space a car should take up in your monthly budget. Probably the best way to figure this out, if you have some time before purchasing, is to estimate your future total vehicle-related monthly expenses for the kind of car you plan to buy, and start putting away that amount in a savings account. 

If after several months you are finding you are comfortable with these “payments,” then you can count on this figure as a realistic one to fit your budget. And now you have a little saved up for a down payment! 


The Bottom Line

Following the 20/4/10 rule of car buying can be helpful to stay within your budget. But even if you can’t follow the rule exactly, the principles behind it will help you navigate the auto market as intelligently as possible for your budget. 

Shoot for the highest down payment amount you can handle and the shortest loan term. Try to accurately estimate the total cost of car ownership for the vehicle you want to buy, and keep monthly payments affordable compared to your income and other expenses. 


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