This guideline can help you limit the amount of debt you carry, which is important for your financial health and your credit score. However, it does have some drawbacks. Learn to calculate the 20/10 rule of thumb, as well as the pros and cons of using it.
What Is the 20/10 Rule of Thumb?
The 20/10 rule set limits on how much of your annual and monthly take-home pay should go toward consumer debt payments. This rule can help you decide whether you’re spending too much on debt payments, and limit the additional borrowing that you’re willing to take on. There are two parts to the 20/10 rule:
20% of annual income: This describes the portion of your annual income that should be spent on debt. When you take into account all your consumer debt, your borrowing should be no more than 20% of your annual income after taxes (your net income). 10% of monthly income: The second part describes how much of your monthly income should go toward debt repayment. Your monthly consumer debt payments should equal no more than 10% of your monthly net income.
How to Use the 20/10 Rule of Thumb
The 20/10 rule of thumb is simple to use because it requires only two easy calculations to make sure you are on track. Start with your monthly after-tax income, which is the amount printed on your check stub or deposited into your account each month. Multiply that amount by 10%. That’s the amount you should spend on debt payments each month, according to the 20/10 rule. For example: If you bring home $5,000 per month, your total consumer debt payments each month shouldn’t be more than $500. Next, look at your annual debt obligations. Multiply your monthly after-tax income by 12 to get your annual after-tax income. Then, multiply that amount by 20%. The total of your outstanding consumer debt shouldn’t be higher than that number. For example: If you bring home $5,000 per month or $60,000 per year, your total annual debt should be no more than $12,000. If your debt obligations don’t fall within the numbers you calculate, too much of your income may be going toward repaying debt. This could be causing financial strain. The 20/10 rule can help you in two ways. It can provide a guideline for managing your money by giving you concrete maximums for how much debt you carry, and it can give you a framework for getting your finances under control. By calculating the maximum amount that you should be putting toward debt repayment, the 20/10 rule can help you set goals to work toward. This can help you decide where you need to change your financial habits as you limit your borrowing and begin to pay off consumer debt.
Grain of Salt
The main benefit to the 20/10 rule of thumb is that it limits your borrowing and the amount of debt you take on. Having a concrete guideline creates structure, which can make it easier to manage your finances. However, the 20/10 rule has drawbacks as well. Whether you choose to follow it may depend on your particular financial situation.
Mortgage
The 20/10 rule doesn’t include your mortgage or rent payment. It only applies to your consumer debt, which includes payments to:
Credit cards Auto loans Student loans Other financing obligations
Lenders will often approve you for a mortgage that brings your total debt-to-income ratio to no more than 43% of your monthly income. This is far higher than the 10% allowed by the 20/10 rule.
Student Loans
The numbers in the 20/10 rule can also be restrictive for anyone with student loan debt. Student loans alone can easily put you close to or over the 20/10 threshold. Using the 20/10 rule would prevent you from taking on any additional consumer debt until you pay down your student loans. If you’re bringing home $5,000 per month, as in the previous example, and your monthly student payments are $400, that leaves you with only $100 each month that you could spend on other consumer debt, such as a car payment, if you follow this rule. While it’s true that you should limit the amount of debt you take on, you don’t have to follow the 20/10 rule to live comfortably. You should, however, minimize the amount of debt you carry and work to pay off all your consumer debt.
20/10 Rule of Thumb vs. 70/20/10 Rule of Thumb
The 20/10 rule of thumb doesn’t address how much you should spend in other categories, such as living expenses or saving for retirement. Instead, it looks only at how much debt you are carrying. The 70/20/10 rule of thumb, by contrast, looks at a more complete financial picture by setting limits on your other spending as well. According to the 70/20/10 rule, you should spend:
70% of your after-tax income on living expenses, such as food, childcare, insurance, discretionary expenses, and your rent or mortgage20% on savings, such as your emergency fund, retirement accounts, college fund, or other savings goals10% on consumer debt, such as credit card payments or a car loan.
Both the 20/10 rule and the 70/20/10 rule provide a framework for managing your finances, limiting your spending, and assessing any debt that you plan to take on. Which system you use depends on your personal spending habits. You may need to try both options to determine which is the better tool for you to use.
Need Extra Help? Don’t Panic
It’s possible that you won’t be able to keep your debt payments within the guidelines suggested by the 20/10 rule of thumb. If this is the case, don’t be afraid to ask for help, whether that be from trusted family and friends or a financial professional. If your debt is becoming unmanageable, you may want to consider a debt management plan, which involves closing your existing credit cards and having a credit counselor negotiate with your creditors on your behalf. Credit counseling services will work with you through this process, building out a payment plan for all the debts you owe, and leading you to a better financial future.
