Liam has a simple rule of thumb - the 20-4-10 rule - to pinpoint just how much you should spend on a car
It’s that time of year, when we start thinking about changing our cars, and according to carzone.ie, the third Monday of January, is the day when people really begin to think seriously about changing their car.
So, as the month draws to a close, I thought it appropriate to share with you some car financing tips. Before you ever start looking at cars, knowing how much you can afford, I think, is the first step you need to take before you trade in your old car for a new one.
There is a great rule of thumb formula which can help you with this, and it’s known as the 20-4-10 rule.
Have a deposit of at least 20% of the purchase price
Finance the car for no more than 4 years
Keep your total monthly expenses (not just your car repayments – insurance, maintenance and tax costs as well) - under 10% of your gross monthly income
Having at least 20%, of the cost of the car helps keep your repayments manageable.
Keeping the term of your loan at four years lessens the amount of interest you repay to the finance house.
And keeping this particular monthly outgoing at less than 10% of your income gives you a little more flexibility, if, you’re hit with an unexpected bill or you lost your job.
How you can apply the 20-4-10 Rule to you.
1. First, know what your gross annual income is.
2. Divide it by 10% and divide that by 12 - this is the monthly amount you can apply towards the cost of owning a car.
3. Deduct 10% to account and pay for other monthly costs.
4. Divide the amount left over by 0.024 and this will give you the amount you should borrow (0.024 is the cost per thousand of borrowing over a four-year term using a rate of 7.5%)
5. Divide the answer to point 4 by .80 and that’s the maximum amount you should pay for a car using a 20% down payment.
Applying the above to an annual income of €60,000
4. €450/0.024 = €18,750 – max amount you should borrow
5. €23,438 – max purchase price
I came across a lady recently earning €50,000, who borrowed €26,000 to purchase a car, and had loan repayments of €635. After only a few months, she is already beginning to feel the pinch.
Had she applied the 20-4-10 rule, she wouldn’t have bought a car costing more than €19,500 and would have limited her borrowings to €15,625. You can see, had she followed this rule, she would owe €10,375 less than she currently does, and as a consequence would have monthly repayments, which would be €260 lower than they are.
Before I continue, it’s worth saying that cars don’t mean a whole lot to me.
I changed my car recently and the one I’m now driving has relatively low mileage, in great condition and is six years old. I plan to keep it for as long as I can.
I didn’t take out a loan when I bought it, I paid for it in cash. I don’t like loans, because I have met far too many people who have put themselves under financial pressure with car repayments, and once the excitement of buying a big car wears off (and it does quite quickly) they are trying to figure out how their outgoings can accommodate this new big expense, and other areas begin to suffer.
So, I personally think paying cash is best. For the three years prior to changing my car, I had, very deliberately, been saving money into a dedicated “new car” account, that was going to be used, when the time came to change the car I was driving.
And this is something I would encourage anyone, to do, particularly if they have a car loan and it’s coming to an end.
Just because the loan is finishing, shouldn’t be the trigger to change your car either, especially if you don’t have to, when your existing car is running fine.
You see, when you finish paying off a car loan, it’s only then when the real savings start to kick in.
When the loan comes to an end, keep making that monthly repayment as before, just redirect it, into a savings account instead.
Then, in two or three years’ time, you might have enough cash along with your trade-in value, to pay for a car outright in cash. Even if you don’t, at least the amount you have to borrow is going down rather than up.
Remember a car is not an investment. They cost a huge amount of money and they become less valuable over time and no matter how great looking it is, they all end up in the same place – the scrap yard.
Liam Croke is MD of Harmonics Financial Ltd,
based in Plassey. He can be contacted at firstname.lastname@example.org or www.harmonics.ie