Our brains are not wired to perform very complex calculations without assistance. Either we need pen and paper to solve. Or a calculator or spreadsheet software to solve complex problems.
Now, if you really want, it is not difficult to find a pen and paper. And mobile phones provide 24X7 access to calculators and spreadsheet software. However, when it comes to making financial decisions, we don’t always use these tools. Instead, we prefer to use thumb rules.
A few common thumb rules in finance.
- Your life cover should be 10-15 times your annual income.
- Your home loan EMI should not be more than 35-40% of your net take-home salary.
- Your portfolio asset allocation should be 50:50 or 60:40 equity:debt.
Now, these rules have common-sense dripping all over. Lots of wisdom and logic. Make intuitive sense.
Yes, you must refine them according to your needs and circumstances, but these are quick and simple starting points. Hence, unless you want to spend time optimizing your decisions (most of us don’t), these thumb rules are good reference points.
Recently, I came across a thumb rule for taking a car loan in an article. I had never heard of it before. The thumb rule is 20:10:4.
What Is the 20:10:4 Rule for Car Loans?
- Pay 20% of the on-road price of the car as down payment.
- The EMI must not exceed 10% of your net take-home salary.
- The tenure must not exceed 4 years.
Not bad, I think. Tells you to put a portion of the cost as down-payment. Keeps EMI size under check. By doing that, it gives you a reality check about the car you can afford.
Just to give an example. Let’s say your net take-home salary is Rs 1 lac. This means your car loan EMI should not exceed Rs 10,000 (10% of Rs 1 lac).
Let’s say the rate of interest for the car loan is 10% p.a. The thumb rule caps the loan tenure at 4 years.
EMI = Rs 10,000, Loan Tenure = 4 years, Car loan interest rate = 10% p.a.
What shall be the car loan amount?
You can use the PV function = Rs 3.94 lacs (Of course, you do not have to use the PV function. While sifting through the loan proposal at the car dealership, you just have to ensure that your loan EMI does not exceed Rs 10,000 for the 4-year loan).
Now, this is the loan amount. Since you are planning to pay 20% down, the maximum cost of the car can be 3.94 lacs / (100% – 20%) = Rs 4.92 lacs. Downpayment of 98K.
| 20:10:4 Rule | |
| Net Monthly Salary (Assumption) | 1,00,000 |
| Car Loan Interest Rate (Assumption) | 10% |
| Car Loan EMI (10% of Salary) | 10,000 |
| Car Loan Tenure (in years) | 4 |
| Car Loan Amount | 3,94,282 |
| Car Price (Loan Amount / (100% – 20%)) | 4,92,853 |
| 20% Down Payment (Car Price – Loan Amount) | 98,571 |
Hence, by following this rule, you know exactly what you can easily afford.
What if I Can’t Buy the Car I Like?
Yes, this can happen. Continuing with the above example, what if the on-road price of the car you want to buy is Rs 7 lacs. Now, this rule was about reality-check.
But you can make small adjustments if your finances permit. How?
#1 Make a Bigger Down Payment (Loan Amount Remains Same)
The affordable loan amount is Rs 3.94 lacs.
Car cost is Rs 7 lacs.
Increase the down payment amount to Rs 3.09 lacs. If you do that, the loan amount will still be 3.94 lacs.
| Bigger Down Payment | |
| Net Monthly Salary (Assumption) | 1,00,000 |
| Car Loan Interest Rate (Assumption) | 10% |
| Car Loan EMI (10% of Salary) | 10,000 |
| Car Loan Tenure (in years) | 4 |
| Car Loan Amount | 3,94,282 |
| Car Price (Loan Amount / (100% – 44%)) | 7,04,075 |
| 44% Down Payment (Car Price – Loan Amount) | 3,09,793 |
Hence, by stretching yourself on the “20” part of the rule, you can stick with “10” and “4” part of the rule.
#2 Pay a Bigger EMI (Loan Amount Goes Up)
If you can’t make a bigger down payment, you can stretch on the EMI part.
Say, instead of 10%, let EMI go to 15% of your net take home salary.
At 15,000 EMI for 4 years at 10% p.a., you can take a car loan of Rs 5.91 lacs. With a downpayment of 96K (less than 20% of the car price), you are almost there.
| Bigger EMI | |
| Net Monthly Salary (Assumption) | 1,00,000 |
| Car Loan Interest Rate (Assumption) | 10% |
| Car Loan EMI (15% of Salary) | 15,000 |
| Car Loan Tenure (in years) | 4 |
| Car Loan Amount | 5,91,422 |
| Car Price (Loan Amount / (100% – 14%)) | 6,87,700 |
| 14% Down Payment (Car Price – Loan Amount) | 96,278 |
However, this is a risky option. Before committing to a bigger EMI for 4 years, consider your cashflows and upcoming expenses.
#3 Increase Loan Tenure (Loan Amount Goes Up)
If a higher downpayment or a higher EMI is not an option, you can increase the loan tenure. The lenders are usually fine with loan tenures of 5-7 years.
By keeping the EMI constant, if you increase the loan tenure from 4 to 7 years, you can get a car loan of Rs 6.02 lacs. With a downpayment of Rs 98K (less than 20% of the car price), the numbers will add up.
| Longer Loan Tenure | |
| Net Monthly Salary (Assumption) | 1,00,000 |
| Car Loan Interest Rate (Assumption) | 10% |
| Car Loan EMI (10% of Salary) | 10,000 |
| Car Loan Tenure (in years) | 7 |
| Car Loan Amount | 6,02,367 |
| Car Price (Loan Amount / (100% – 14%)) | 7,00,427 |
| 14% Down Payment (Car Price – Loan Amount) | 98,060 |
#4 Use a Mixed Approach
A slightly higher down payment. A bit more than 10% of monthly income as EMI. Slightly longer than 4 years.
Continuing with the same example. Let’s say the car price is 7 lacs.
You can pay Rs 1.2 lacs in downpayment (i.e., slightly less than 20% of the car price). You take a loan of Rs 5.8 lacs.
You take a car loan with a tenure of 5 years at 10% p.a.
Instead of Rs 10,000 as EMI, let’s say you can stretch to Rs 12,500 in EMI.
The EMI for such a loan will be 12,323. Within your EMI cap of Rs 12,500.
As you can see, thumb rules don’t give you perfect answers but can certainly give a good starting point for customization. What do you think?