Planning to buy a car: Follow the 20-10-4 formula to reduce monthly installment burden

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With the second Covid-19 wave ebbing, you might be planning to buy a new car in a while. If you do, chances are more than not that you are going to apply for a loan.

While taking a loan, it is useful to remember a 20-10-4 formula that many personal finance advisers suggest. But just like any other rule, it might vary from individual to individual according their monthly income and other liabilities.

The formula

According to the 20-10-4 rule, one should be able to foot 20% of the on-road price of the car as down payment while booking the vehicle.

The equated monthly instalment (EMI) should not be more than 10% of the monthly income and the loan tenure should be for a maximum of four years.

Suppose your monthly income is Rs 1 lakh. If we consider a car the on-road price of which is Rs 7 lakh, you should offer a minimum of Rs 1.4 lakh as down payment, and the EMI should be around Rs 10,000.

Car loans at 7.5-8%

In this case, you would need to take a loan of Rs 5.6 lakh for four years. At present, most lenders are offering car loan starting at 7.5-8%. Let us consider the interest rate of 8%. Then the EMI would be around Rs 13,500, which is Rs 3,500 more than the limit according to the rule.

In that case, either you have to make more down payment, or the price of the car should be less than Rs 7 lakh. Otherwise, you could face some financial stress.

That is why experts suggest that one should go with a car the on-road price of which is half of your annual CTC. In this case the person should choose a car under Rs 6 lakh.

According to the rule, for a Rs 6 lakh car down payment would be Rs 1.2 lakh and the loan amount would be Rs 4.8 lakh. And for a 4-year car loan, the EMI would be Rs 11,700, which is more convenient than the previous instance.

Other options

The impulse to buy that dream car often prompts one to throw rules and caution to the wind. In such an instance, experts suggest other avenues.

First, instead of 20%, make down payment of 30-35% which would reduce the EMI burden.

Second, go for a 5-year loan period, though it will actually increase the loan repayment amount. The EMI burden would be less.

Third, during the pendency of the loan if you get some excess money, just pay the bank and reduce the EMI, or reduce the tenure.

Bottom line

“In these models, everything is considered in a conservative way. These figures and formula are not cast in stone. It might vary from person to person,” said Arvind Agarwal, Kolkata-based CFA.

However, these are thumb rules that one follows.