This post is part of an ongoing series called “Deconstructing Financial Rules Of Thumb,” where I break down generally accepted financial principles and give you my opinion if they are worth following.
Buying a vehicle will be one of the biggest purchases of your life.
It’s not uncommon to spend tens-of-thousands on a car, and that doesn’t include the ongoing costs (cost vs. price) associated with maintenance and repairs.
But how can you know the appropriate amount to spend on a vehicle?
In a past article, I discussed the adverse effects of lifestyle creep. Allowing yourself to spend more on purchases like a car, just because you make more money is a sure way to stunt your ability to build true wealth.
Enter, the 20/4/10 Rule…
THE 20/4/10 RULE
This is a financial principle to help you pinpoint how much you should spend on a vehicle.
It states that when buying a car, you should…
- Put down at least 20 percent of the purchase price
- Finance the car for no more than 4-years
- Spend no more than 10 percent of your gross income on monthly transportation costs
When it mentions total monthly transportation costs, this includes your car payment, gas, insurance, etc. You have to think more along the lines of your budget than just the purchase price of your car.
What you’ll notice is that it didn’t mention the purchase price based on your income level. You need to work backward from the ongoing costs to find your ideal purchase price.
This rule helps prevent you from spending too much on a vehicle, getting yourself in over your head.
It puts the focus on your budget, which forces you to think of the long-term effects of your purchase, and the ongoing costs.
The one scenario that this rule falls short with is when a person is making a mid-to-low level income and has a long commute.
In a scenario like this, it might be challenging to keep your total transportation costs under 10%.
I really like this rule. The main reason I love it so much is that it helps to control spending behaviors before you’re in a buying situation.
Studies have proven that humans are bad decision makers, especially when it comes to money. (See here and here) When most people go to make a car purchase, they aren’t thinking about the long-term ramifications of their decisions, or how the amount they spend will affect their budget, and subsequently, their ability to buy or invest in other things in the future.
People only think about how many features they can squeeze into their purchase, and are often upsold by the car dealership on why they need the fully-loaded package.
Putting constraints on your purchase before you even go out there to look at cars allows you to know precisely the direction you will go in.
In essence, it allows you to make decisions – like adding on new features – before they are even presented to you.
Overall, I’d give this financial principle two thumbs up!