Cars are great. They make life more convenient, give you the freedom to go wherever you want to and they look good too. The society we live in attaches the type of car that you drive to how much money you have or how wealthy you must be. If you are seen driving a Mercedes Benz, for instance, that would mean that people assume that you have a lot of money. On the other hand, driving your dream car makes you feel good and gives you a sense of achievement as well.
There is absolutely nothing wrong with having the desire to drive your dream car. I personally want to drive a Mercedes regardless of how expensive it will be. The problem is that most of us young people may push to drive these cars before we can actually afford to pay for them.
One of the main goals of your 20’s should be to set the right foundation for your personal finances. Invest in the right products that will ensure your financial freedom some day. So driving a vehicle that you cannot afford yet, may hinder that progress.
So how much car can you actually afford?
When I bought my first car, my bank told me that they would not finance a car that cost more than 25% of my gross income. Although you can spend between 10% to 50% of your gross income on car repayments, the general rule of thumb is that you should not spend more than 35% of your pre-tax income on car repayments.
Going by the rule, you will find that you probably qualify to buy that expensive vehicle that you may have been eyeing. Although the bank may be willing to give you a loan that high, it does not mean that you should take it. What’s the alternative? Use the 20/4/10 rule to budget for a car that you can actually afford.
What is the 20/4/10 rule in vehicle financing?
According to the 20/4/10 car financing rule, you need to out down a 20% car deposit, you can finance it for no longer than 4 years and the monthly payments (including the instalment, insurance, maintenance and other expenses) below 10% of your gross monthly income.
This rule works best for the following reasons:
- Putting down a deposit that is less than 20 % of puts you in a position where you will owe more than the cars value almost immediately. According to smallbusinesschron, a new car will lose approximately 20 percent of its value in the first year and 15 percent each year after that. This means that you will owe more than the car’s value for most of the repayment period. If you need to sell the car before paying off the loan, you’ll probably have to come up with the difference between the car’s value and the balance on your car loan. This basically means that you pay money to sell your car??? This doesn’t sound fun at all.
- The recommended loan repayment period is 4 years because the longer the term of your loan, the more interest you pay. The longer your loan term, the longer you’ll have to meet your lender’s insurance requirements, which often means higher rates. Besides, after 4 years your car would have lost most of its value and you might not want to still be paying for it.
- Your dream car isn’t worth having if your monthly payments eat up all the extra room in your budget. Staying below 10 percent means you’ll have money to put toward other things—like an emergency fund, a vacation, kid’s college fund or down payment on your house. It also means a change in circumstances—say, a pay cut or a job loss—won’t turn your vehicle into a burden on you.
How much car can Stacy afford (An Example)?
The Delayed Gratification Option
The better option for Stacy is to buy a cash car, save for 4 years and then buy the car she wants in 4 years.
So it would go like this:
1 —-> Stacy buys a car worth $ 5 000 (which would have been her down payment)
2 —> She starts saving $ 458/month (which have been her monthly repayments) for 4 years
3 —> Her savings will grow like this: $ 11000 by end of Year 2, $ 16000 by end of Year 3 and $ 22000 by end of Year 4.
So Stacy can afford the car that she wants in 4 years and the best part is that she pays $ 0 interest to the bank.
Take Home Points
The smartest way to buy a car is to buy it cash. However, this is not a good option for all of us. The 20/4/10 rule provides another option that will not leave a huge dent in your account and hinder your progress towards financial freedom. If you are disciplined you could take it a step further and choose the delayed gratification option where you save up for the car you want.
Which option works best for you? Let us know in the comments section below.
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