Imagine you’re in the market for a new vehicle. Where do you begin your car-buying process? Do you already have a dream make and model in mind? What’s your budget? Are you already browsing the interwebs for the car you want? If you are, you’re already starting off on the wrong foot — at least according to the 20/4/10 rule.
What is the 20/4/10 rule?
The 20/4/10 rule helps car shoppers figure out how much car they can actually fit into their budget before falling in love with a vehicle they can’t afford. It emphasizes calculating what you can afford before you set out shopping.
The rule might seem obvious — before you buy something, you should make sure you can afford it, right? — but it gets tricky when it comes to financing, and many don’t take the time to include annual ownership costs. If you don’t, you could end up with monthly transportation costs that could force you to live paycheck to paycheck or take on more debt.
Follow the 20/4/10 rule, and you might avoid accidentally biting off more than you can chew.
Rule #1: Put down at least 20%
A vehicle is a depreciating asset. The experts at Carfax estimate a new car loses 10% of its value the moment you drive off the lot. And the depreciation continues from there. Edmunds.com estimates a new vehicle loses over one-fourth of its value in the first year alone. For that reason, you should be prepared to put down at least 20% of the purchase price. If you do this, you’ll finance payments for the vehicle’s actual estimated value when you leave the lot instead of the full purchase price, which the vehicle isn’t worth anymore.
Take this example: You finance a new car for its full purchase price of $34,000, then lose your job the next day. Now, you might need to sell your new car, but you can sell it for only $30,600 — because the car already lost 10% of its value once it left the lot. Since you put $0 down at financing, you’ll still owe $34,000 after the sale. On the other hand, if you’d put down at least $6,800, you could sell the car that day for its estimated value and only lose out on half your down payment.
You might not be able to estimate exactly how much car you can afford, but if you are able to put down at least 20% of the purchase price, you should be in an OK financial position. On top of that, you’ll have smaller payments and possibly finance it for a shorter period.
Rule #2: Finance the vehicle for no more than four years
The longer your financing agreement is, the more you’ll pay in interest over time. So don’t be swayed by dealers or lenders who try to sell you on a lower monthly car payment — chances are your payment is so low because the term of your loan is long.
You can use the MagnifyMoney loan calculator to see this rule at work. If you borrow $25,000 to purchase a car (at a 4% APR) and agree to a six-year financing deal, you’ll wind up paying $3,161 in additional interest charges by the time you pay off the loan.
If you agree to a four-year loan instead, you’ll pay just $2,095 in interest — a savings of over $1,000. Of course, that shorter term loan also comes with a higher monthly payment — $564 versus $391 — but you are saving more over the long term.
Think of it this way: If you can’t afford the monthly payment required to pay off the car in four years or fewer, it’s probably outside of your budget.
Rule #3: Keep your total transportation costs under 10% of your monthly income
This last part is where it gets easy to overspend. You should try to keep your total transportation costs — your car payment, insurance, gas, and maintenance — under 10% of your monthly income.
So, if you earn $5,000 per month, your total transportation costs shouldn’t cost more than $500.
How to save on the cost of a new car
Try these tips to keep your overall transportation costs low.
Get pre-approved for financing
Avoid financing your vehicle through the dealer, and get pre-approved for financing at a lower rate before you show up at a dealership. Financing your auto loan at a lower rate can reduce your monthly loan payment. If you walk onto the lot with a pre-approved auto loan rate from a bank or credit union, you can use that as leverage for negotiation.
However, if you let the dealer find the loan for you instead, you’ll lose negotiating power, and there won’t be a way for you to tell if the dealer’s loan rate is the best offer you can get. Avoid making these other common mistakes when searching for a car loan.
More people are purchasing used cars than ever before and saving a bundle in the process, according to Edmunds. Over 38 million vehicles sold in 2015 were used, a year-over-year increase of 5.6%.
When you buy used or certified pre-owned vehicles, you avoid financing a larger balance, and could even skip financing altogether if you’ve got enough cash on hand. If you buy used, avoid engine trouble by having the vehicle inspected by an independent mechanic before you sign off. You can use a resource like Car Talk to find a mechanic in your area.
Buy a car that holds its value
Depreciation is a car owner's largest transportation expense during the first five years of ownership, more than fuel, maintenance, and even insurance.
A car that holds value well will depreciate less over time compared to the average vehicle, so you may not lose out on as much in depreciation costs if you sell the vehicle after a few years. Carmakers like Honda and Porsche are known for building vehicles that hold their value well over time according to Kelley Blue Book.
Leasing a car will usually result in a lower monthly payment, and you’ll likely save money with a lower down payment and lower tax fees over time. However, you could be subject to extra charges if you ding up the vehicle, or drive more miles than stated on the lease agreement. It doesn’t always work for everyone, so consider your personal needs first.
On the plus side, you’ll upgrade to a new vehicle every few years and won’t need to deal with the hassle of selling a car.
Look for gas savings
Gas isn’t always an unavoidable expense. You can make a few changes to your fueling habits like filling up before you hit “E” or signing up for a gas rewards credit card to save money. You could also cut down transportation costs by cutting back how often you drive or by carpooling some days to school or work. Learn more ways to reduce your gas spend here.
Don’t get lazy with must-haves like maintenance and insurance for your vehicle. Comparison shopping is the best way to save on costs like these that may differ from provider to provider. Insurance companies have made it easier to compare quotes with online comparison portals like this one from Progressive. You could also try going through your bank or credit union for discounted rates with select companies.
Don’t just take the first estimate you get for a repair. Mechanics are known to pad the bill with unnecessary repairs from time to time. After you figure out what’s wrong with you vehicle, get an estimate from a few different mechanics in your area. That way you’ll make sure you’re getting the best value before paying for maintenance and repairs.
MagnifyMoney is a price comparison and financial education website, founded by former bankers who use their knowledge of how the system works to help you save money.