There is no dream sweeter than owning a car. In fact, it is one of the craziest dreams you could have as a teenager. If you walk into any teenager’s bedroom, you may see a poster of their dream car stuck on the wall.
Having an addiction to cars and bikes is much better than having an addiction to other substances and behaviours because it can give teenagers a higher purpose and motivate them to study better. If your children are teenagers, encourage them to put up images of their favourite bike or car on the wall.
Many years later, the car they buy could be totally different from the one they had dreamed of. Either their interest in the car may have changed, or the job they took up might not pay enough for them to afford it. This is perfectly normal, as life’s other priorities may catch up with them and they may have to settle for a more utilitarian car.
Just because other priorities have caught up with you does not mean you need to give up entirely. There could still be a way to make it work. Use my 20:5:20 rule to check whether the car is affordable. If it is, go for it.
The 20:5:20 rule explained
| Component | Rule |
|---|---|
| Down payment | 20% of the car’s on-road price |
| Loan tenure | 5 years |
| EMI | 20% of your monthly income |
There are two ways to approach this rule:
Top-down
Bottom-up
The top-down approach begins by identifying the car and then calculating the finances.
For example, if the on-road price of a Hyundai Creta is ₹24 lakh, the rule works out as follows:
| Particulars | Calculation | Amount |
|---|---|---|
| Down payment | 20% of ₹24 lakh | ₹4.8 lakh |
| Loan amount | ₹24 lakh minus ₹4.8 lakh | ₹19.2 lakh |
| Loan tenure | 5 years | |
| Assumed interest rate | 8% | |
| EMI | EMI on ₹19.2 lakh at 8% for five years | ₹38,930 |
| Required monthly income | ₹38,930 divided by 20% | ₹1.95 lakh |
| Required annual income | ₹1.95 lakh multiplied by 12 | ₹23.4 lakh |
The interest rate on the loan can be entered manually. Assuming an interest rate of 8%, the EMI works out to ₹38,930.
The EMI of ₹38,930 should be 20% of your monthly income. Hence, your monthly income should be more than ₹1.95 lakh.
You need a monthly income of at least ₹1.95 lakh, or an annual income of ₹23.4 lakh, to afford this car.
The bottom-up approach begins by calculating your monthly income and then determining what car you can afford.
For example, assume that your monthly income is ₹3 lakh, which translates into an annual income of ₹36 lakh.
| Particulars | Calculation | Amount |
|---|---|---|
| Monthly income | ₹3 lakh | |
| Annual income | ₹3 lakh multiplied by 12 | ₹36 lakh |
| Maximum EMI | 20% of ₹3 lakh | ₹60,000 |
| Approximate loan amount | Five-year loan at 8% with an EMI of ₹60,000 | ₹29.5 lakh |
| Down payment required | ₹29.5 lakh divided by 4 | ₹7.37 lakh |
| Maximum value of the car | ₹29.5 lakh plus ₹7.37 lakh | ₹36.87 lakh |
The EMI should be less than 20% of your monthly income. In this example, it should therefore be less than ₹60,000.
The five-year loan amount could be approximately ₹29.5 lakh at an interest rate of 8%, assuming that you are ready to pay an EMI of ₹60,000.
The 20% down payment required would be ₹7.37 lakh. The maximum value of the car you could buy would therefore be ₹36.87 lakh.
You could think about buying a Toyota Innova Crysta.
You can use the free SEBI EMI calculator to make these calculations.
The 20:5:20 rule is a palindrome, meaning that you can use either the top-down or bottom-up approach and still arrive at the same results. This engineered rule will ease stress and help you zero in on the best car you can afford based on your current income.
If the EMI is considerably higher than 20% of your income, it could cause financial stress. Sooner or later, you might regret purchasing the car.
This is because a car depreciates in value over time. Even if you trade it in, the amount received may not fill the financial void it created.
I know that buying a car is more of an emotional decision than merely a financial one. But since you have learnt the 20:5:20 rule and are able to fit your car purchase into this formula, the final outcome will be sensible.
Disclaimer
Investments in the securities market are subject to market risks, including the potential loss of principal. Past performance does not guarantee future results. The information provided is for educational purposes only and should not be considered financial advice.
Investors should read all related documents carefully and consult a certified adviser before investing. Registration granted by SEBI, enlistment with RAASB/BSE and certification from NISM do not guarantee the performance of the intermediary or provide any assurance of returns to investors.
Investors are requested to consider all the risk factors before trading in stocks or derivatives. The SEBI RIA licence INA000021757 and RA licence INH000025045 are held by Balachandran RV.