Wherever you come from, whatever you do in life – there are a few things that will make up most of your expenses. Housing, sustenance, education and means of transportation are just the main examples (healthcare is excluded as it’s usually available to taxpayers in developed countries). This time we’ll take a look at some pre-requirements of purchasing a car.
It’s not difficult coming up with a reason why anyone should acquire a means of personal transportation. Work, family, pleasure, or simply convenience – there are many benefits to owning a car. And, considering that the legal age for driving in most countries varies from age 17 to age 18, the likelihood that a person spends money on a car before education or housing is quite high.
Sure, the car that you bought with the cash you earned working over the summer while in high school is not going to be either the most expensive or last you for very long. And once you settle into adulthood, your needs will simply outgrow that car. Even if you haven’t bought a car until now, perhaps the necessity to do so – just like life – is catching up with you. So, we’re not going to go into any models and makes. Rather, the financial aspect of purchasing a vehicle.
What is the 20/4/10 rule?
This rule is a guideline for anyone who might be looking to buy a car with the help of a loan. It’s not intended to discourage you in any way. Merely to help you make a financially sound decision in choosing your next vehicle.
We’ll look at each section separately, starting with the first. As with purchasing a property, when you take out a loan (or lease) for a car, you have to make a down payment. The percentage of the down payment may vary, depending upon the country of issuance, the credit score of the buyer and the type of loan. However, the 20/4/10 rule – specifically the ‘20’ part of the rule – states that the buyer should be able to pay 20% of the car price as the down payment.
The next part of the rule covers the period of time for the loan you intend to take out. Typically, for car leasing and loans, banks offer time frames between 3 and 7 years. This rule suggests that the buyer should finance the loan for a period no longer than 4 years.
And finally, this rule also proposes that the buyer spends only up to 10% of monthly income towards total transportation expenses per month. That includes not only the loan payment, but also car insurance, maintenance and petrol.
What is the purpose of following this rule?
First, this rule should help you in the process of choosing your next vehicle. A sort of ‘rule of thumb’ when it comes to determining which car fits your budget. Generally, if you can’t follow this rule with the car that you’ve picked, it’s likely that it’s outside your price range.
Secondly, following this rule could help you save a significant amount of money. Here, it’s important to understand that a car is a depreciating asset – an asset that loses value over time, and rather quickly. Experts at the Automobile Association estimate that a new car might lose its value by as much as 20% per year. It doesn’t mean that your brand-new car will cost nothing in 5 years. Nor does it mean that all used cars are created equal. Mileage and maintenance do play a significant role in how quickly a car drops in value. But, depreciation is real, and you can’t escape it, even if you keep your vehicle under a sheet, locked in a barn somewhere.
Once you acknowledge this inconvenient truth, you can use the tools at your disposal to diminish this loss of value. The 20/4 parts of this rule are just such tools. For example, the higher your down payment, the less you’ll owe over the life of the car loan. And the shorter the loan period, the less depreciation of value. While the benefit might not seem as obvious initially, doing this will make your loan cheaper, shorter and keep your depreciating car value at least in the vicinity of the remaining loan amount.
The percentage of your down payment will also help you manage the loan period and make the monthly payments more affordable. Depending on your credit score, banks may offer you loans without the necessity of a down payment. However, the less money you pay up front, the more expensive the loan will be, overall. Either the period of the loan will exceed 4 years, since you’ll have to repay the full price of the vehicle, plus interest. Or, your monthly payments go way up, since:
• once again, you have more of the loan to repay
• the bank will increase your interest rate, as 0 down payment loans are deemed more risky
Out of all three parts of this rule, the last one might be the hardest to follow. 10% of your monthly income might seem like a lot. And, it actually is a lot. And if you do your due diligence in choosing the most affordable, economic model that’s also cheap to insure and maintain – congratulations. However, as previously mentioned – unless you keep your car locked up, losing all of its purpose in the process – the car will lose its value. And it will demand its share of your budget in order to use and maintain it.
The loan payments, insurance costs and maintenance will cost an arm and a leg, but, overall in Europe these costs are affordable. But..
While in some countries around the globe, petrol would be the cheapest portion of transportation costs, it’s the other way around in Europe. Depending on your habits, petrol might cost you up to and even more than the loan payments for your car. So, while it’s suggested to keep the costs at or below 10% of your income – try and at least keep them under 20%. Otherwise, the car might be out of your price range, and you should look for other options.
Should I use the 20/4/10 rule?
Yes, absolutely! While every one of us has a specific financial situation, we can all use rules like this for general guidelines. The 20/4/10 rule will help you determine whether the car you have in mind is actually affordable for you. And will help you figure out the best way to finance this purchase. Remember, the higher your down payment and shorter the loan period – the less interest you’ll pay. In turn, that will help you reduce your monthly transportation costs. It’s okay to stray from the numbers a bit. As long as you make well calculated decisions that make sense for you, both financially and convenience-wise.