Manage Money

What is the 20/10 Rule?

If you find yourself constantly on the verge of overspending with your credit cards, consider using the 20/10 rule to keep your spending in check. The 20/10 rule is a simple guideline for keeping your debts at a manageable level.

What is the 20/10 Rule?

The first part refers to your overall debt. Excluding mortgage debt, you should keep your borrowing total below 20% of your annual after-tax income. This includes credit cards and debts such as student loans, as well as car loans and any similar installment debt.

Mortgage debt is excluded for two reasons. A mortgage debt has some positive aspects, allowing you to build equity in an appreciating asset as compared to buying depreciating or disposable assets. On a more practical level, the sheer size and long-term aspect of a mortgage relative to other debts generally swamps the other types of debt you are trying to analyze.

The second part of the 20/10 rule relates to monthly payments and cash flow. Your goal is to keep your payments on all the loans and credit cards to no more than 10% of your monthly after-tax income. Again, mortgage payments are excluded, along with rent (since it is just another form of monthly housing payment).

In practical terms, if you have a large mortgage payment or live in a high-rent area, you may have to adjust the rule. If you are spending up to half of your net income on housing – not an unfamiliar situation for some who are underemployed – you probably cannot afford to extend your credit to 20% of your net income.

Diverging from the 20/10 Rule

You are just one surprise expense away from a debt spiral and need to focus instead on saving to build an emergency fund. If you do have an emergency fund, you can consider loosening your credit somewhat – just use common sense.

This illustrates a point about the 20/10 rule – it is a general guideline that makes general assumptions, such as starting with some degree of initial financial stability, stable regular income, and proportionate housing expenses. Your situation may require a different strategy.

Keeping your debt at 20% of your income, without a regular income, is somewhere between difficult and impossible.

For example, if you are recently unemployed, have suffered a pay cut, or have an unpredictable income, keeping your debt at 20% of your income is somewhere between difficult and impossible. You do not need a general guideline – you need a more detailed plan to guide your debt strategy until you get to a more stable place financially.

Student loan debt can also skew this equation, because of the massive increase in size, which can approach that of a modest mortgage. Defaulting on student loan debt also carries significant penalties, and limited options for discharge. Creditors can repossess your house for partial recovery, but they cannot repossess your education… yet. (Let’s hope that no agency is researching that.)

You may run into an unavoidable expense, such as an uncovered medical bill, that throws you over the 20/10 level. In that case, you need to evaluate the situation and make your plan to get back slowly to the 20/10 mark – unless your situation requires cuts that are more drastic.

What Should You Do?

In summary, there may be times where you should bend the 20/10 rule. If you are in a difficult financial situation, you will have to cut spending even further and focus more on reducing your high interest debt. However, for most borrowers, the 20/10 guideline provides an excellent rule of thumb to keep from overextending credit – or at least make you think hard about certain purchases before you whip out your credit card.


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