Should You Follow the 20/10 Rule for Debt Management?

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Carrying the right of amount of debt (if really there is such a thing) is important for your financial health and for your credit score. If your debt payments are too high you could overstress your budget and have a hard time meeting your other financial goals. When it comes to credit cards, carrying too much debt is harmful to your credit score. Following the 20/10 rule can help you keep your debt in check.

What Is the 20/10 Rule?

Many people find it helpful to have a rule or guideline to stick to when it comes to budgeting. For example, it may be easier to know that you should only spend 1/3 of your income on your mortgage payment. These types of guidelines can help you make consistently reasonable financial decisions. When it comes to taking on debt, some people stick to the 20/10 rule.

The 20/10 rule defines how much of your annual and monthly take home pay should go toward your consumer debt payments. You can use the 20/10 rule to decide whether you're spending too much on debt payments. The rule doesn't include your mortgage or rent payment. It only applies to your consumer debt. That means credit cards, auto loan, student loans, and other financing obligations.

There are two parts of the 20/10 rule. The first part applies your annual income. When you take into account all your consumer debt, your borrowing should be no more than 20 percent of your annual income after taxes. So if you bring home $80,000 per year, your total debt shouldn't be more than $16,000.

The second part considers your monthly income. If you bring home $5,000 for example, your monthly debt payments shouldn't be more than $500.

Applying the 20/10 Rule to Your Finances

It can be easier to start with your monthly after-tax income since it's printed on your check stub or deposited into your account each month. Multiply that amount by 10 percent or .10. That's the amount you should spend on debt payments each month according to the 20/10 rule.

Now, total your monthly consumer debt payments. Is it more than 10 percent of your monthly after-tax income? If so, it could explain any financial strain you're currently experiencing.

Multiply your monthly after-tax income by 12 to get your annual after-tax income. Then, multiply that amount by 20 percent or .20. The total of your outstanding consumer debt shouldn't be higher than that number. 

Should You Follow It?

It's hard to say the 20/10 rule is a bad thing, especially if it keeps you from getting into too much debt. However, the numbers can be restrictive, especially for people with student loan debt. Student loans alone can easily put you close to or over the 20/10 threshold which means you wouldn't be able to take 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 $300. That leaves you with only $200 each month that you should spend on a car payment. If you were going car shopping today and were pre-approved for a 5-year loan at 4.8 percent, you'd only be able to spend $10,650. You'd be buying a used car or a very inexpensive new car.

Following the the 20/10 rule would certainly keep you from taking on more debt than you can afford. It would prevent you from getting in over your head on debt payments, make it easier to live within your means, and leave you with money leftover for your other financial goals. Sticking to the rule could be difficult and would require some sacrifice.

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.

The 20/10 rule is a guideline, not a hard fast rule. Your finances will be better if you stick to it, but you won't be penalized if you don't. When you're applying for a mortgage, for example, the lender will look for a debt-to-income ratio of less than 36 percent of your monthly income, which a lot more flexible than the 10 percent allowed by the 20/10 rule.