Liam Croke: Apply the 20/4/10 rule when buying a car

Following on from my article last week, I received a number of emails from people, some of whom were shocked that someone could owe so much on a car loan.

Following on from my article last week, I received a number of emails from people, some of whom were shocked that someone could owe so much on a car loan.

In the example I gave this particular women spent about half her annual salary on the cost of a car. I also received a number of emails from people saying they were in the same position as she was, saddled with car loans they can barely afford and regretting they ever bought the car in the first place.

What I have found is that the amount people owe on car loans, doesn’t immediately start off big (in some cases, of course, it does) but gradually builds up over time.

The problem is that as they change their car, their existing vehicle has depreciated so badly that the trade-in value becomes quite low. So if they are upgrading to a newer model, the cost of bridging that gap has increased – and obviously they’re borrowing more.

Let me point out from the outset that cars don’t mean a whole lot to me. As long as it can get me from A to B then I am happy. I actually changed my car recently and the one I am now driving has relatively low mileage, is in great condition and is seven years old.

I plan to keep it for as long as I can. The car loan I took out to purchase it is with me and not a bank.

You see, I don’t have a car loan but it didn’t stop me putting money away each month into an account that I would eventually use to pay for a new car outright, in cash, when I changed it.

This is something that I would encourage people to do if they have a car loan and it’s coming to an end. Don’t change your car just because your loan has ended – keep making that monthly repayment, just put it into a savings account instead.

Then, two or three years later, you might have enough cash along with your trade-in value to pay for a car outright in cash. If you don’t, at least the amount you have to borrow is going down rather than up.

Let me put some numbers together to show you this. Let’s say your car repayment previously was €350. If you kept the car for another two years and saved that €350 every month, you would have €8,400. If you kept your car in good shape, and it was worth, say, €5,000, then you can purchase a car costing €13,400. It might not be a brand new model but I think you would get a very good car for that amount – something that would last you for another five years.

At the end of that time, with no car loan in place and if you continued to save that €350, you would have saved €21,000 plus interest. If the value of your car depreciated by 60% over five years you would have another €5,000 – so you will be able to purchase a car as nice or nicer than you bought five years earlier, but this time for cash.

For me, when I started using my savings on cars rather than borrowing it from the bank instead, I found I had less interest in having a big, expensive car and more interest in the other things I could do with money i.e. going on a holiday every year, overpaying on my mortgage, saving to put my kids through college and so on.

If you don’t have savings to buy a car outright then of course you are going to have to borrow money from a bank or a credit union. If this is the case, borrowing the right amount is the key for me. And my advice to people in this regard is to use the 20/4/10 rule which is

n Have a deposit of at least 20% of the purchase price.

n Finance the car for no more than four years.

n Keep your total monthly expenses (not just your car repayments - insurance and tax costs as well) - under 10% of your gross 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 bank 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.

Let me give you a real-life example. I’ll show you what that person I was telling you about last week should have borrowed if she had followed this rule. To refresh your memory, she was earning €50,000, owed €26,000 and was paying €635 per month on her car loan.

Using the 20/4/10 rule, a person earning €50,000 per year, who has saved 20% of the purchase price and has annual insurance/tax payments/maintenance of around €1,500 per year, should buy a car costing no more than €14,951 and should limit their borrowing to €11,961, repayable over four years maximum.

Had she followed this rule she would owe €14,000 less than she currently does, and as a consequence would have monthly repayments that are €342 lower and would end up paying €2,412 less in interest payments. I hope the car she bought was worth it!

Let me leave you with some tips that will hopefully prevent you in the future from driving a car you can’t afford.

First, drive the car you have now for as long as you can so that after you pay it off you can save up for its replacement.

Take care of the car you have so you don’t have to buy a new one.

Don’t try to keep up with the Joneses if they decide to upgrade theirs.

Educate yourself on the total cost of ownership of a car – and remember a car is not an investment. They nearly all end up in the same place – the wrecking yard.