Car Buying Guidelines Based on Income - The 20/4/10 rule


When it comes time to start looking for the next car (as we are slowly preparing for now), there is a guideline out there that can help keep your monthly car expenses in check. It’s the 20/4/10 guideline.

As a disclaimer, we don't like car loans and think paying cash is best, but I also realize that other people have different thoughts on debt than I do and so, I offer this guideline as some food for thought when it comes to buying a car.

What is the 20/4/10 guideline for buying a car?

The 20/4/10 guideline puts parameters around three car buying factors that will affect your monthly budget.

  • Put 20% down on the car you are purchasing.
  • No longer than a 4-year car loan.
  • Total monthly expenses (principal, interest, and insurance) total 10% or less of your monthly gross income.

This three-pronged approach to figuring out how much car you can afford should keep you from overextending your monthly budget to the point of financial strain. It does have some flaws, but we’ll discuss those a little later. Let’s talk a little more about each parameter and how you can use it as a guideline for your family car budget.

Put 20% Down on the Car Purchase

As I’ve stated before, we’ve got a seven-plus year streak going without a car payment. I can’t imagine having a car payment, but I have also talked with too many folks who have stretched themselves too thin with car payments and drive around with the regret and tight budget trying to figure out how to correct their situations. It’s just not worth it for us.

IF… and that’s a big if… you think you have to have a car loan, the 20% down rule is a good one. It shows a level of commitment to the purchase and requires savings before getting what you want.

If you can follow this rule, you’ve show the ability to save up a few thousand dollars before purchasing. It shows discipline and should slow down your car purchase process and help you make a more rational decision about the depreciating asset you are about to buy.

But… paying 100% down is still better...

No Longer Than a 4-Year Car Loan

In a world where car manufacturers are touting six year, zero percent interest loans on brand new vehicles, I realize I’m fighting an uphill battle in convincing you on this guideline. In some cases, car loans are extending to seven years!

The good news is that in 2015 the length of new car ownership was at 6.5 years up from 4.3 years in 2006 (reported on CNBC). Length of used car ownership in 2015 was 5.3 which was up about two years from 2006. So, Americans are hanging onto their vehicles longer, but with a seven year loan on a new car, the average person wouldn’t even be owning it long enough to pay it off and truly own it.

If you must get a car loan, and can follow the four year guideline, you will have your car paid off faster than the average length of ownership and be able to save up to improve your next car buying experience in the final few years for the next car. This is key to breaking the car payment cycle. You must at some point make the decision to never have a car loan again. That will take some initial shift in cash flow and priorities.

Don't Forget About Auto Insurance

Another cost you should factor in when considering a car loan is the auto insurance. If you have a loan, your state likely has laws around how much auto insurance you have to have while you are making payments. Think of it kind of like private mortgage insurance (PMI) in the home ownership realm. Once your loan is paid off, you can further reduce your monthly car expenses by dropping the collision on your insurance because the loan doesn't need to be paid off if something happens.

A good rule of thumb on when changing your auto insurance policy is when your car is worth less than $3,000 or when the premium is 10% or more of the car’s value.

Monthly Expenses (Loan & Insurance) Total 10% or Less of Monthly Gross Income

Remember that cars are depreciating assets, and while we might "need" them to get around, the type of car and total cost we pay for them doesn’t have to mean a brand new vehicle with all the bells and whistles.

This 10% rule keeps the "lifestyle factor" of buying a car in check with overall income. If our gross income for the month is $5,000, then our car payment (principal and interest) plus the insurance for the car shouldn’t exceed $500 per month.

I can’t state this enough… buying a car without a loan is the best way to go. Saving up and paying cash is the absolute best affordability tool you can utilize. It truly makes the car buying experience one in which you pay for what you need. You’ve worked hard and saved up, and while you might "need" a car, you’ll think a little harder knowing how long it took you to save up to the level of car you are looking for.

The 20/4/10 Rule Applied to a $5,000 / Month Gross Income

If your household gross income is $5,000 per month, then the 10% rule would mean you have $500 per month to spend toward a car and cover insurance per month. I’m going to estimate that insurance would cost $65 per month.

Knowing this, I now need to figure out how much car I can purchase with the remaining $435. I used a quick car calculator (google it) with a 5% interest rate and 48-month term. With those parameters I can acquire a $19,000 loan with a $438 car payment. (I’ve already over-extended myself by $3 per month!)

If I can get a loan for $19,000, I still need to put 20% down to satisfy all the parameters of the 20/4/10 car affordability rule. $19,000 * 1.20 = $22,800 total for the car purchase.

$22,800 - $19,000 = $3,800 for the 20% down payment. Which means you’ll have to save that before going to purchase the car.

Assuming you are looking to upgrade cars sometime in the future as opposed to an immediate (emergency) situation, why not just drive what you have for another year or two and continue to save at the rate of what the car payment would be?

This follows Dave Ramsey’s idea of upgrading cars by paying yourself a car payment every month while you drive a beat up old car to get you by.

Upgrading cars by paying yourself a car payment

  • You own a car worth $1,500.
  • Save the car payment we determined earlier: $435/month.
  • In 10 months you have $4,350 in cash plus your $1,500 car.
  • Buy a different used car for $5,850, and keep saving your $435 per month.
  • 10 more months later you have another $4,350 saved and a car worth about $5,000.
  • Sell your used car and use that money along with your savings to buy a $9,350 car.
  • 10 months later, do it again and get a $13,000 car, etc.

So, even if you are coming off of a decent sized car payment and can save those dollars for the next purchase, you can work your way back toward a nicer used car over time.

After all this math and walking through some scenarios of the 20/4/10 rule, I still come back to paying cash for a car that’s just going to depreciate. The whole mindset locked into the rule (in my opinion) is the mentality that you "must" have a car payment and if you "must" have a car payment, then this is the conservative way to go about it.

And while I think the rule helps keep you from overextending yourself on a car purchase, there are still better alternatives… save up and pay cash.

What's your car buying strategy?