Buying a car with the 20/4/10 rule explained

Purchasing a car is often one of the most significant financial decisions an individual or a family makes. Buying a car usually ranks second to purchasing a house or property as it requires a substantial financial investment. However, the excitement of owning a new vehicle shouldn’t overwhelm your finances. Thus it becomes even more important to plan the expenditure. The 20/4/10 car buying rule is a widely recommended financial guideline that helps car buyers make sound financial decisions. Afterall, a new car shouldn’t outweigh the responsibility of ensuring that the purchase doesn’t strain your finances. This golden rule of car buying prevents one from financially overextending themselves.

CARS24 has compiled an in-depth guide into the 20/4/10 rule, explaining each component in detail to provide practical advice as well as tips and tricks on how to successfully implement it. Got a car buying hack of yourself? Share it with the CARS24 auto community, CLUTCH, where there are more interesting automotive discussions taking place.

What is the 20/4/10 car buying rule?

In simpler terms, the 20/4/10 car buying rule is a financial guideline that suggests how much you should spend on a car relative to your income. It provides a clear structure and plan for how you should go about managing your car loan. In essence, the 20/4/10 rule suggests buying a car while following a calculation of 20 per cent down payment, 4 year loan tenure and 10 per cent of monthly income towards car expenses. We explain further below– 

1. 20 per cent down payment - While availing the maximum loan you’re eligible for, may seem attractive and even viable, the rule suggests aiming to make a down payment of at least 20 per cent of the car’s total on-road price.

2. 4-year loan tenure - Extending a loan tenure to lower monthly EMIs is convenient and may help you in managing your monthly payments but the rule emphasises on limiting your car loan term to a maximum of four years.

3. 10 per cent of monthly income towards car expenses -  Running a car is an on-going expense thus the rule suggests that the total car-related monthly expenses should not exceed 10 per cent of your gross monthly income.

These may seem like fairly straightforward rules or suggestions but their application is more nuanced thus requiring delving deeper into each element of the 20/4/10 car buying rule.

How does the 20/4/10 car buying rule work?

For this rule to work, the foremost condition is to budget the total cost of the car to a maximum of 50 per cent of your annual income. This will not only help you shortlist a set of cars that can fit your budget but also put a cap to the budget itself so you’re not tempted to buy a car that overextends it.

As a result, if your annual income is ₹20 lakh, the car you’re looking to buy should not exceed an on-road price of ₹10 lakh. This ratio of course, will progressively go up as your income increases. Thus, for someone earning ₹30 lakh annually, they can select a car that costs ₹15 lakh on-road. Do factor in mind, the time of purchase as well, as an appraisal or bonus around the corner would mean that you may be able to widen your selection of cars. 

Now that the cost of the car has been set at 50 per cent of your annual income, let’s take a look at the various components of the 20/4/10 car buying rule.

The importance of a 20 per cent down payment

A down payment is the initial amount of money, outside the loan component, that you pay upfront when purchasing a car. A 20 per cent down payment is significant, but reaps numerous benefits in the long run.

Lowers the loan amount - By paying 20 per cent of the car’s price upfront, you reduce the amount you need to finance. This by far is the most helpful aspect of a larger down payment sum. For example, if you’re buying a car priced at ₹10 lakh, a 20 per cent down payment would be ₹2 lakh. This leaves ₹8 lakh to be financed or loaned rather than the full ₹10 lakh.

Lowers monthly payments - A knock on benefit of the ₹2 lakh down payment in our example would now mean that interest on the loan amount is reduced. Thus instead of paying interest for a sum of ₹10 lakh, you now pay interest on ₹8 lakh. This will in turn lower your monthly instalment payments. Your overall monthly costs on the car will reduce and this will help you manage your monthly expenses better.

Reduces overall interest costs - A lower loan amount also means you’ll pay less interest over the tenure of the loan. Interest is calculated based on the principal amount, so reducing that principal by making a significant down payment will save you money in the long run.

Avoids negative equity - Cars depreciate the moment they leave the showroom thus factoring it in, is vital. Negative equity occurs when the value of your car drops below the amount you still owe on your loan. This can happen if you finance the entire purchase price of the car with little to no down payment. Making a 20 per cent down payment helps protect you from being in this unfavourable financial condition. This is especially relevant if your choice of car has poor resale and depreciates faster than others.

The relevance of a 4-year loan tenure

Sticking to a 4-year loan term requires careful planning and discipline. This is an important aspect because stepping outside the 4-year loan tenure stipulation will have consequences on your monthly expenditure on the car. A lower monthly EMI upon choosing a longer loan duration can be lucrative but will amount to a higher amount of total interest paid plus doing so, will also risk running into negative equity. There are some steps you can take to discipline yourself into a maximum of a 4-year loan term.

Choose an affordable car - One of the best ways to ensure that you can stick to a 4-year loan term is to choose a car that’s lower in price to the 50 per cent budget as stated earlier. Focus on finding a vehicle to fit in this set budget thus lowering your down payment requirement as well as loan amount and the monthly EMI.

Increase your down payment - The 4-year element of the 20/4/10 rule of car buying is vital so giving it more importance will prove beneficial. If possible, opt to put down a larger sum of money as down payment rather than extending the loan tenure. This will in turn reduce the principal amount of the loan, making it easier to stick to a 4-year term with manageable monthly instalments.

Shop around for the best loan offers: Different banks offer different interest amounts and loan terms. Shopping around to find a suitable mix of lower interest rates over a period of four years will make it easier to stick to a 4-year loan term.

Continuing with our example above where we ascertained the car budget to a maximum of ₹10 lakh. A 20 per cent down payment would be ₹2 lakh, leaving ₹8 lakh to be loaned. With an average interest rate of 8 per cent per annum for four years, you will end up paying a monthly EMI of ₹19,530 and a total interest amount of ₹1.37 lakh.

On the other hand, if you instead select a loan term for six years, your EMI surely reduces to ₹14,027 but the total interest paid goes up substantially, to ₹2.10 lakh.

Limiting total car expenses to 10 per cent of monthly income

The final component of the 20/4/10 rule for car buying is the 10 per cent dedicated to total car expenses in a month. This means that your total car-related expenses, including the loan EMI should not exceed 10 per cent of your monthly in-hand income. This rule factors in associated costs of running and owning a car, such as fuel, maintenance, repairs or any unforeseen costs that may be incurred. This element of the rule is to ensure that your car expenses don’t take up too large a portion of your monthly income, leaving room for other financial obligations as well as savings.

In our running example, your annual income was set to ₹20 lakh. This would translate to a monthly income of ₹1.67 lakh. With the 10 per cent rule applied, your monthly budget to include the loan EMI on the car as well as running costs of the car, should not exceed ₹16,700. This ensures that you’re not overextending yourself financially and that you have enough left over for other living cost essentials.

As calculated previously, the monthly EMI amounted to ₹19,530 on a loan of ₹8 lakh at 8 per cent interest over four years. The EMI is well over the ₹16,700 of allowed monthly expenses as per the 10 per cent rule. This now means that you will have to either increase the down payment or find a bank offering a lower rate of interest or ultimately, select a car that costs less than the original ₹10 lakh budget.

Strategies to stay within your 20/4/10 budget

Our example proved that the rule’s strict guidelines may not deem a car costing 50 per cent of your income, as a viable choice. This may seem harsh at first but, after determining and deducting your monthly expenses for living costs, the 10 per cent allocation of car-related expenses will, in most cases, come out as the best budget cap along with sticking to the 4-year loan tenure term. So what else can you do to still buy your car of choice while sticking to the 20/4/10 rule as much as possible? 

Consider other car options - You can either opt for a lower variant of your selected car or even go for the base trim instead. A top-variant of a smaller car might even be better. Alternatively, don’t overlook the possibility of choosing a used car instead. A second-hand vehicle might fall well inside of the stipulated budget while still offering all the features that you desired from the new car.

Increase the down payment percentage - As mentioned before, this is an option with the least financial consequence later on and may delay your car purchase but has numerous benefits. If you have the means to increase the down payment percentage from the minimum of 20 per cent as per the rule, you might still be able to afford the ₹10 lakh car from our running example. In turn, this will further allow you to stick to the 10 per cent monthly expenses rule as it will definitely lower your loan amount thus monthly EMIs as well.

Research and evaluate other loan options - Apart from mainstream banks, various financial institutions offer car loans. Based on your individual credit rating, you may be able to come across one that offers a more favourable rate of interest. It is advisable to compare interest rates offered by these institutions as well as various banks to maximise your benefits.

Potential drawbacks to the 20/4/10 rule

The 20/4/10 rule, although helpful in setting baseline budgets for your car purchase as well as its running cost, can be vastly limiting. Our running example proved the same and deemed it unfit to buy a ₹10 lakh car with the 20/4/10 car buying rule applied. As mentioned, it is best to treat the rule more as a guideline than a hard and fast financial application. 

For instance, there may be merit in considering the ex-showroom price instead as registration, insurance  and other charges making up the on-road price is mostly a one-time expenditure. This difference in ex-showroom and on-road price can be absorbed in a down payment addition. Consequently, this will lower the loan amount required thus monthly EMIs while you still get to buy the car you originally planned for. Some of the drawbacks of the rule are - 

Limited options - The 20/4/10 rule may severely limit your car options as has been demonstrated in the above example. This limitation can extend to compromises on model, variant and features selection.

Necessitate a higher down payment - Saving up a 20 per cent down payment can be an unreasonable requirement based on your current financial situation. However, your future financial situation may be set to improve thus a lower down payment and higher loan amount may very well be feasible for you. Alternatively, saving for a higher down payment may cause you to lose a good deal or wait longer for the purchase when your requirement for a car is now.

Inflexibility on loan period and car-related expenses - The 20/4/10 rule limits the loan tenure to four years. In some cases you may get a lower rate of interest on a loan tenure for five years thus offsetting some of the losses on extending the loan tenure. The 4-year loan tenure can also be difficult to adhere to for lower incomes or individuals with other financial commitments.

Running costs of a car may vary too depending on reliability, wear and tear rates, varying fuel costs and running conditions of a car. Thus the fixed nature of the 10 per cent limit of car-related expenses may not suit everyone. A car enthusiast for instance, may want to spend closer to 15 per cent on monthly running and upkeep costs of the car. They may not want to compromise on their selection of car either.

When to use or avoid the 20/4/10 car buying rule

While the rule aims to stabilise your expenses on the car, there are various scenarios where the rule might be best avoided. Conversely, the rule makes the most sense for buyers with a high level of financial control and prioritisation on limiting expenses. Sometimes, a car purchase might be an entirely emotional decision and that’s alright too. The rule may not be entirely applicable in this case. Whatever the scenario, the 20/4/10 rule can always act as a baseline for sound financial planning around buying a car.   

Use it -

• If you closely track your finances.
• If you have to stick to a certain monthly budget for expenditures.
• If your choice of car isn't based on very focused needs.
• If long term investment is more of a priority.
• If you are a first-time car buyer with little to no knowledge of running costs of a car. 

Avoid it -

• If you don’t have a regular stream of income.
• If your financial situation limits your savings.
• If you foresee getting better financial aid to foreclose your loan.
• If you have higher financial liabilities.
• If your selection of car and its features cannot be compromised upon. 

The bottom line

Buying a car is a financial decision as much as it is about deciding on what car to get. The former requires a fair amount of individual financial assessment in order to reduce the financial burden of such an expenditure. This becomes even vital considering that cars start depreciating as soon as they roll out of the showroom floor. The 20/4/10 car buying rule helps you manage your car expenses within a stipulated budget, avoid unnecessary debt and maintain financial stability. This rule helps eliminate the financial stresses of the purchase and becomes a set of guidelines to keep in mind. It can be modified to suit your situation and isn’t a hard and fast rule. Rather, it only provides the means to making a sound financial decision to help you further enjoy the experience of buying a new car.   

FAQs

Q. How much should I spend on a car based on my salary in India?

The 20/4/10 car buying rule limits your car budget to 50 per cent of your annual income. The rule is universally applicable and not specific to any region around the world. So be it India or otherwise, you can make this rule work as long as your selected car’s on-road cost is capped at 50 per cent of your yearly salary.

Q. What is the best period to buy a car?

The best time to buy a car in India is usually around the festive season approaching Diwali. This is a time when most manufacturers extend heavy discounts and benefits while financial firms too may offer lower interest rates or value add-ons. One can also consider the calendar year-end/beginning of the new year purchases when dealers offer attractive discounts to clear outprevious model year manufactured stock.  

Q. How much car loan can I get on a ₹40,000 salary?

Banks offer car loans to salaried individuals earning upwards of ₹25,000. As a general rule, banks may offer loans up to 3-4 times of your annual income. The exact amount of loan will depend on your credit rating/CIBIL score and other criteria.

Q. What is the golden rule for car loan?

As the article above suggests, the 20/4/10 car buying rule is a great financial tool to use as the golden rule of car buying. Work out 20 per cent of the down payment, limit the loan tenure to 4 years and allocate 10 per cent of your monthly income towards the monthly running costs of the car that includes your loan EMI amount.

Q: Can I modify the 20/4/10 car buying rule based on my specific financial situation?

You can surely modify the 20/4/10 rule to suit your specific needs and situation. Planning on financial expenditure is purely personal thus catering to your specific requirements can be done using the 20/4/10 rule as a guideline.