In this article:
- What Is the 20/10 Rule?
- When Does the 20/10 Rule Not Apply?
- Pros and Cons of the 20/10 Rule
- 20/10 Rule of Thumb vs. 70/20/10 Rule of Thumb
The 20/10 rule of thumb is a budgeting technique that can be an effective way to keep your debt under control. It says your total debt shouldn't equal more than 20% of your annual income, and that your monthly debt payments shouldn't be more than 10% of your monthly income.
While the 20/10 rule can be a useful way to make conscious decisions about borrowing, it's not necessarily a useful approach to debt for everyone. Here's what you need to know about how the 20/10 rule works, the pros and cons and other ways to think about debt management.
What Is the 20/10 Rule?
The 20/10 rule uses your income as a guide to limit your debt. You can think of it as a system for how you can avoid building up so much debt that it becomes a burden, or as a goal to aim for if your debt is already too much.
This rule of thumb applies to different types of debt obligations, including credit card payments and installment payments toward personal loans, dental or veterinary payment plans, payday loans, BNPL plans, auto loans and student loans. The 20/10 rule does not consider mortgage costs or other housing expenses (more on that later).
By setting a self-imposed limit on your total debt of 20% of your yearly net pay and a limit on your monthly debt obligations of 10% of your monthly net pay, you may be more inclined to think twice before taking on more debt.
Example of How to Use the 20/10 Rule
To use the 20/10 rule, start by looking at your monthly take-home pay—that's your pay after taxes are taken out. You can find it by looking at the pay stubs you receive from your employer, the dollar amount on your paycheck or the amount of your direct deposits.
For this example, consider Tom, a hypothetical borrower who has a take-home pay of $50,000 per year. In this example, 20% of Tom's $50,000 income is $10,000. According to the 20/10 rule, Tom's total debt should fall below $10,000.
Dividing Tom's annual income into 12 months, we see that his take-home pay is about $4,167 a month. Using the 20/10 rule, Tom should keep his monthly debt obligations below 10% of that number, which equals about $417 a month.
When Does the 20/10 Rule Not Apply?
When using the 20/10 rule of thumb, don't include mortgage or monthly rental payments. Instead, include your monthly housing payments in your monthly expenses category of your budget.
In general, the 20/10 rule may not apply well for everyone's personal financial situation. For instance, you don't necessarily need this rule of thumb to decide whether you're strained by your debts. You might determine your debt levels are manageable simply because your monthly payments are affordable, and you aren't revolving high-interest debt from one month to the next.
Pros and Cons of the 20/10 Rule
The 20/10 rule can be a great way to keep debt tenable and avoid financial strain, but it also has certain downsides to keep in mind. Consider the following before you incorporate this rule into your budgeting strategy.
Benefits of the 20/10 Rule
- It helps you limit debt. The biggest benefit of the 20/10 rule is that it helps you mind how much you're borrowing to avoid too much debt. It's in your favor to be cautious about taking on new debts, and the 20/10 rule can be a useful framework for guiding your decisions.
- It can help you come up with a repayment goal. If you're currently grappling with high balances and want to chart a course out of debt, you can use the 20/10 rule to set a goal. For instance, say you have an $8,000 auto loan balance and $2,000 in credit card debt with an annual net income of $35,000. You could use the 20/10 rule to set a goal for yourself to reduce your debts to $7,000 (20% of $35,000). That means you have to pay off $3,000 in debt to meet your goal.
- With less debt, you'll have room to grow financially. By keeping debt in check, you can focus on growing wealth through saving and investing. You can also limit debt-related stress and enjoy more financial freedom by keeping overheard down.
Downsides of the 20/10 Rule
- It doesn't always apply. The 20/10 rule considers mortgage debt as a monthly expense, rather than debt. And beyond that, many people may carry other types of debt that would put them over the rule. If you have high student loan payments, for example, the 20/10 rule may not be the right gauge for your financial health.
- Lenders don't use the 20/10 rule. Lenders look at how much debt you're carrying in relation to income to determine whether you're likely to struggle to meet your monthly financial obligations. But they use a different metric: your debt-to-income ratio (DTI). To find your DTI, add up your monthly payments due and divide by your monthly gross pay. Lenders tend to look for a DTI below 43%, and that includes mortgage payments.
- Credit cards can complicate matters. Credit cards have minimum payments, which is the dollar amount card issuers require you to pay every month. By only making your minimum credit card payment in order to stick to the 20/10 rule, your credit card balances may balloon to unmanageable levels. Have a plan to pay off your credit cards as quickly as possible to avoid interest charges.
20/10 Rule of Thumb vs. 70/20/10 Rule of Thumb
The 20/10 rule of thumb is a guideline for handling debt, but it doesn't provide you with a complete blueprint for how you should be budgeting your money. On the other hand, the 70/20/10 rule is a budgeting plan that you can use alongside this debt management technique to manage your income.
According to the 70/20/10 rule, you should:
- Allocate 70% of your take-home pay toward all of your expenses and discretionary spending, including your housing payment, bills, groceries, transportation and any retail, dining, entertainment or other spending you do.
- Allocate 20% of your take-home pay toward your savings and investment accounts, including your emergency fund and any sinking funds you use for other savings goals.
- Allocate no more than 10% of your take home pay toward debt management.
For example, say you have a monthly after-tax salary of $4,000. You would allocate $2,800 toward all of your expenses and spending, $800 toward savings and $400 toward debt. This may or may not work for you depending on how much debt you have and how quickly you're trying to pay it off.
As you solidify your budget, it's important to keep experimenting until you find a method that works for you and your goals. If you find yourself having trouble sticking to your budget, you might want to rethink your approach.
The Bottom Line
Using a debt management rule of thumb such as the 20/10 rule can help you keep your feet on firm financial ground by avoiding going into too much debt. That's of major importance because—alongside budgeting, saving and investing for retirement—a healthy relationship with debt will help you become or stay financially secure.
In addition to being strategic in how much you borrow, keep an eye on your credit. Check your credit report and credit score for free through Experian to see how the amount of debt you carry and your history of monthly payments are impacting your credit. You can also sign up for free credit monitoring for alerts to changes in credit usage or any new activity listed on your credit report.
As a seasoned financial expert with a wealth of knowledge in budgeting and debt management, I bring a depth of understanding to the concepts discussed in the provided article. My extensive experience in the field allows me to dissect and analyze the 20/10 rule with a keen eye for its practical applications, limitations, and its comparison to alternative budgeting strategies.
The 20/10 rule, presented as a budgeting technique, advises individuals to ensure that their total debt does not exceed 20% of their annual income, and their monthly debt payments should not surpass 10% of their monthly income. This rule of thumb is applicable to various types of debt, excluding mortgage costs or other housing expenses.
To illustrate the application of the 20/10 rule, the article provides an example involving a hypothetical borrower named Tom, emphasizing the importance of setting self-imposed limits on both total and monthly debt obligations. It highlights the significance of using this rule to make conscious decisions about borrowing, preventing the accumulation of burdensome debt.
The article also addresses situations where the 20/10 rule may not be applicable, specifically noting that mortgage or monthly rental payments should not be included in the calculation. It emphasizes that individual financial circ*mstances vary, and some may find the rule less suitable for assessing their debt levels.
Pros and cons of the 20/10 rule are discussed in detail. On the positive side, it helps individuals limit their debt, serves as a framework for setting repayment goals, and contributes to financial growth by keeping debt manageable. On the downside, the rule may not consider certain types of debt, such as high student loan payments, and lenders typically use a different metric, the debt-to-income ratio (DTI), to assess financial health.
Furthermore, the article introduces an alternative budgeting strategy, the 70/20/10 rule, which allocates 70% of take-home pay to expenses, 20% to savings and investments, and no more than 10% to debt management. This rule offers a comprehensive approach to managing income alongside the 20/10 rule for debt management.
In conclusion, the article emphasizes the importance of adopting a debt management rule of thumb, such as the 20/10 rule, to maintain financial stability. It suggests that alongside budgeting, saving, and investing for retirement, a healthy relationship with debt is crucial for financial security. The bottom line encourages individuals to be strategic in borrowing, monitor credit, and experiment with budgeting methods to find an approach that aligns with their goals.
