Buying a new car is a major decision that involves spending several thousand dollars. If you’re financing the purchase, you may be required to come up with a down payment. So, how much should you save for that? This is an important question to answer before applying for a personal loan to buy a car or agreeing to do dealer financing.  

The 20/4/10 rule for buying a car

A down payment of 20% of the selling price of the car is the best way to go. The 20/4/10 rule combines that with a four-year term on the loan and a monthly payment that is no more than 10% of your total monthly income. This is a formula that is used to determine affordability. If the math works, you can afford to buy the car.

There are variations on this, like the 20/3/8 rule, that works if you make over $150,000 per year. The constant is the 20% down payment. It’s tough to come up with if you’re buying a new car with a sticker price of $40,000 or more, but the four-year loan suggested by the 20/4/10 rule means that you’ll pay the car off before it depreciates below 50% of its initial value.

The down payment should cover first-year depreciation

A new vehicle will depreciate by 20% in the first year that you own it. A down payment of 20% covers that depreciation, ensuring that you won’t go “upside down” on the loan within the first twelve months. Vehicle depreciation after that is roughly 15% a year.

This is important because the buyer can’t refinance an auto loan if they’re underwater on it. The book value of the car needs to be more than the amount due on the loan. Car buyers who “score” no-money-down deals on auto purchases run the risk of being stuck with a high-interest loan for the entire term. Banks won’t refinance them if there’s no equity in the vehicle.

Using a trade-in or a 10% down payment

Most dealerships will allow you to use your old vehicle as a down payment on the new one, provided it’s in decent shape. This approach will lower the amount that you need to borrow to pay for the car, but it may not be equal to putting down 20%. It’s recommended that you come up with an additional down payment in cash if that is the case.

A 10% down payment won’t fully cover the depreciation of the first year, but you can always make an extra payment each month to compensate for that. Make sure that you mark the payment as “principal only” when you do this so you’re not simply paying off interest and fees. Doing this consistently could shorten the term of your loan.

The Bottom Line

A 20% down payment covers your vehicle’s depreciation for the first year. Combining it with a four-year loan term and keeping your monthly payments down to less than 10% of your total income is considered responsible personal finance. Putting 10% down and adding extra “principal only” payments each month could accomplish the same thing.