Americans worship the automobile. Right or wrong, it's a centerpiece of our culture. It can also be a financial stumbling block for the unwary or intentionally ignorant.
If you're like me, you probably drive down the road or through parking lots and wonder, "where do people get the money to buy these cars?" Having worked with thousands of families over the years, I can say that, too often, those wheels are the product of bad decision-making.
In this series, I've been exploring various financial rules of thumb. Here, I'll tackle one such rule designed to keep you from bowling through the guard rails with your next vehicle purchase.
Rule of Thumb: The 20/4/10 rule (20% down payment, 4-year max loan term and cap of 10% of gross income on auto expenses)
Why: There are few buying decisions as emotionally loaded as an auto purchase. In the past, I've shared my own missteps in this area. And frankly, most of them would have been avoided had I applied this rule of thumb. Drawing a line in the sand as to what is or is not an acceptable purchase -- from a financial perspective -- well in advance of beginning the shopping process is a way to set yourself up for success.
Assessment: When you make a mistake with a big-ticket purchase like a vehicle, it can haunt your finances for years to come. Having a financially sound framework to guide your decisions is a good thing.
I think this rule of thumb provides a helpful, but probably optimistic, guideline for your next vehicle purchase. I say “overly optimistic” for two primary reasons. First, the 20% down payment. I view this as "nice to have" as opposed to necessary. In fact, retaining the cash, or half of it, may provide you with more financial flexibility than using the money for a down payment while still allowing you to exit the dealer owing less than the car is worth.
Furthermore, I'm OK with extending the maximum term of the vehicle loan from four to five years. Unfortunately, the trend in car loan lengths is toward longer and longer loans, and that's not good. Limiting the length of your car loan and clearly defining "affordable" in terms of monthly outlays can really help you steer clear of vehicle problems. That's why I do like the 10% cap on transportation expenses offered in this rule of thumb.
On the whole, strict adherence to this rule of thumb would yield big improvements in the average American's finances; and even if it might be a bit aspirational, it's a good thing.