Here’s how the rule works so you can figure out how to apply it to your own finances, plus some insight on when it might make sense to bend the rules to fit your circumstances.
How Does the 20/4/10 Rule of Thumb for Car Buying Work?
The 20/4/10 rule uses straightforward math to help car shoppers figure out their budget. According to the formula, you should make a 20% down payment on a car with a four-year car loan and then spend no more than 10% of your monthly income on transportation expenses. That 10% spent on monthly transportation includes your auto loan payment, maintenance, gas, and car insurance. For instance, under the 20/4/10 rule, a person making $70,000 should aim to spend less than $700 per month on transportation costs. When you calculate 10% of your own monthly income, you can then use your budget to figure out whether you can afford that monthly payment. For example, if your annual income is $75,000, your monthly budget should show you whether you have a surplus of $750 to dedicate to an auto loan payment, plus other transportation expenses.
Why the 20/4/10 Rule of Thumb Generally Works
For most people, the 20/4/10 rule is a simple enough guide to stick to for car shopping. Understanding your budget in advance gives you more negotiating power when you’re shopping around. Using our example from earlier, someone who makes $75,000 a year and sets aside 10% of their monthly income—$750—for transportation costs. As auto loan interest rates—and therefore, your monthly payment—hinge on your credit score, they also impact your car loan amount. For example, a car buyer with a very good or excellent credit score of 720 to over 800, could qualify for a low annual percentage rate (APR). On the other end of the spectrum, a car buyer with a low credit score, between 500 and 589, may qualify for an APR that’s four times as high as someone with excellent credit. Here’s how credit scores translate to your car-buying decision. Sticking to a monthly car payment of no more than $540 means a person with an excellent credit score could borrow $24,000 and manage a total vehicle purchase price of $30,000 (including the 20% down payment). On the other hand, buying with a low credit score could limit you to a loan of around $20,000 and a total vehicle price of $25,000. Furthermore, the car buyer with the low credit score could ultimately pay around four times the interest on a four-year loan as a buyer with excellent credit who purchases a more expensive vehicle with a four-year loan.
Grain of Salt
The 20/4/10 rule of thumb doesn’t work for all car-buying situations. While the rule does allow you to spend up to 10% of your monthly income on transportation costs, your other monthly expenses may not allow you to spend quite that much. In addition, you may be able to spread your payments over five or six years instead of four to lower your monthly payment. According to vehicle valuation and information source Kelley Blue Book, the average cost of a new car in October 2022 was around $48,000. Assuming your gas and insurance costs are $400 a month, you would need a monthly income of $12,540—or $150,480 per year—to stick to the 20/4/10 rule, even if you have excellent credit. Adjusting your budget is another option for affording the monthly payment on a new car, if your other monthly expenses are low. If this is the case, you can increase the 10% part of the rule, allowing you to afford a car with a higher price tag.
