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

Couple paying bills on laptop

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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. High debt payments can overstress your budget and leave you struggling to meet your other financial goals.

When you also consider that carrying too much credit card debt is harmful to your credit score, it becomes critical to come up with a strategy for lowering your outstanding balances. 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 spend no more than a third 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 consumer 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. Following this rule helps you quickly decide whether you're spending too much on debt payments.

There's one limitation of the 20/10 rule—it 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, and other financing obligations.

There are two parts of the 20/10 rule. The first part applies to your annual income. 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). 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. Your monthly consumer debt payments should equal no more than 10% of your monthly net 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

Start with your monthly after-tax income is easier since it's printed on your check stub or deposited into your account each month. Multiply that amount by 10% (.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% of your monthly after-tax income? If so, this 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% (.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 five-year loan at 4.8%, you'd only be able to spend $10,650, which limits your options to a used car or a very inexpensive new car.

On the plus side, following 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 left over for your other financial goals.

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 only approve you for a mortgage that brings your total debt-to-income ratio to no more than 43% of your monthly income—obviously more flexible than the 10% allowed by the 20/10 rule. When it comes to debt planning, the most important thing is to determine your limits and stick to them.

Article Sources

  1. "What's In My FICO Score?" Accessed Oct. 15, 2020.

  2. Wells Fargo. "Maintain Your Good Credit," Accessed Oct. 15, 2020.

  3. Consumer Financial Protection Bureau. "What Is a Debt-to-Income Ratio? Why Is the 43% Debt-to-Income Ratio iImportant?" Accessed Oct. 15, 2020.