Do you feel like you're drowning in debt, struggling to save, and don't know where to start when it comes to paying down your debt? You're not alone. In fact, according to a recent poll done by the Federal Reserve Bank of New York’s Center for Microeconomic Data , every US household has some kind of debt, with the national debt average reaching over $15 trillion in debt.
As someone who paid off $150k in student loan debt, I know how overwhelming it can be to manage a budget, try to save for your life goals, and get out of debt at the same time.
But don't worry, there's a simple yet powerful strategy rule of thumb that can help: the 10/20 rule.
This rule was a great gut check when I was trying to manage my consumer debt early in my career and helped me on my journey to becoming debt free. The 10/20 rule is a debt management strategy that can give you a clear roadmap for paying off your debts and achieving financial independence.
In this post, I'll explain what the 10/20 rule is, how it works, and how you can use it to create a budget and debt payment plan that works for you. Whether you're struggling with credit card debt or just looking for a better way to manage your finances and debt, the 10/20 rule can help you take control of your money and start to chip away at your debt so you can become financially free.
What Is the 10/20 Rule?
The 10/20 rule, also known as the 20/10 rule, is a guideline to help consumers determine how much they owe in debt. It’s meant to be used as a barometer or gut check to help you gauge whether your financial situation is on the right track or veering towards the proverbial cliff due to your increasing debts.
Using rules of thumb, like the 10/20 rule, can help you get a clear picture of where you stand with your spending. It can also give you an idea of how much you owe in consumer debts.
So, what do the numbers stand for?
First off, the ‘20’ in the 10/20 rule refers to the total amount of your debt, which shouldn’t be more than 20% of your annual net income. This is your after-tax, take-home pay. However, bear in mind that this rule doesn’t apply to your mortgage debt or rent payments. It only takes into account your consumer debts, like student loans, credit card debt, medical loans, and car loans.
On the other hand, the ‘10’ stands for the amount you should put into paying off these debts. In other words, 10% of your monthly income after tax deductions should go toward debt repayment.
So, the first step after understanding how the 10/20 rule works is to put it into practice.
How Does the 10/20 Rule Work?
The main purpose of the 10/20 rule of thumb is to help you get a handle on the debt you already have. However, the big benefit in my opinion is that it helps you avoid taking on more debt than you can afford. This rule is an effective way of putting how much you owe with respect to your annual and monthly take-home pay.
So let's walk through how to calculate these two percentages.
10% of Your Monthly Income
The 10% part of this rule is to help ensure that you keep up with your debt payments with the hope of cutting down your consumer debts.
It’s also there to ensure that your debt repayments don’t exceed 10% of your monthly take-home pay.
Applying the 10% Part of the 10/20 Rule
Let’s use the same example as above. To apply the 10% part of the rule, we calculate 10% of your net monthly income. This should tell us how much you should set aside to pay off your debts.
Say, for example, you bring home $50,000 a year after taxes and other paycheck deductions like retirement savings. To find out how much you make in a month, divide that annual income by 12.
That means your monthly net income is $4,167.
The next step is to multiply that $4,167 by 10% or 0.10 to give you how much you should spend on monthly debt payments. That should come to about $417, which is the maximum amount you should put towards repaying your debts each month.
Here’s another formula that can help make things a bit easier to follow:
P (% of pay allocated to debt payments per month) = (annual take-home pay/12) x 0.10
What if my monthly payment is higher than 10%?
Some people may have debt payments that exceed the 10%. Usually, this is because a lot of us carry a significant amount of student loan debt where the minimum payments exceed 10%. If your number is higher than 10%, try to limit taking out any additional debt until you pay off some of the consumer debt you have today.
Additionally, you may have a higher than 10% monthly payment because you're on an aggressive debt paydown plan to become debt free and accelerate your path to financial independence. That's ok! That's great actually. This rule of thumb should be used as a gut check on how much debt you should be taking on and if you're making the minimum progress each month.
20% of Your Annual Income
To put a figure on the 20% part of this rule, start by making listing out all your consumer debts. Then, check to see if they exceed 20% of your annual after-tax income, not your gross income. Your after-tax income is the amount of money you have available to spend each month after taxes are deducted.
As mentioned above, this rule doesn’t take your mortgage payments into account. However, again it does include the following:
- Student loans
- Credit card loans
- Car loans
- Payday loans
- Medical debts
Applying the 20% Part of the 10/20 Rule
Here are two examples to help you visualize what we mean by the 20% part of this rule. To apply it to your finances, use the following formula:
DI (% of debt vs. income) = (debt/take-home pay) x 100
Still following the same example as above, your annual take-home pay, aka your net pay, is $50,000 after taxes. At the same time, you owe $2,000 in credit card debt and $5,000 in student loans. Plus, you have a $10,000 balance on your car loan.
First, add up all the debts to find out how much you owe. Using the same numbers as an example, you should get a total of $17,000.
The second step is to divide that sum ($17,000) by your net income of $50,000. This means your debt is 34% of your annual take-home pay.
While this percentage is in the normal range, you probably want to work on a debt paydown strategy to get one step closer to financial independence. As the rule states, you should try to keep it at 20% or lower. Anything higher means you need to pause in taking out more debt and get on a debt paydown plan to lower your debt percentage.
Lenders and the 10/20 Rule
Before signing off on a loan, lenders will be more interested in your debt-to-income ratio than the 10/20 rule.
The majority of lenders will only consider borrowers with a higher debt-to-income ratio than the typical 20% of your monthly income. For most, this amount needs to be at or slightly below 36%, whereas some may even consider a higher ratio of up to, but not exceeding, 43%.
Nevertheless, if you want to become financially independent well before the traditional retirement age, your best bet is to stick to the 10/20 rule to start. Then, once you get your debt-to-income ratio in a better place, you can maximize your eligibility for loans when you need them and at much better interest rates.
The 10/20 Rule: Pros and Cons
Having a personal rule like the 10/20 rule helps you set up a budgeting method to help pay off your debts as quickly and efficiently as possible. Yet, as with anything in life, there are two sides to this plan: the good and the bad.
Pros
The first advantage of the 10/20 rule is to help determine how much you can pay each month on your consumer debts. It’ll also help you assess the current state of your debt-to-income ratio. It's a great gut check to see if you're on the right track with managing your personal loans and consumer debt.
This way, you'll know exactly how much you owe and how much more debt you can take on. Or, if you’re carrying around large amounts of debt, this rule can help you map out when you’ll be able to lower that threshold and boost your finances once again.
Another feature of this debt plan is that it’s more comprehensive than others. It may not help with building a detailed budget, but it does help you map out the debt side of your budget.
Cons
While the 10/20 rule comes with a handful of benefits, it has a few drawbacks as well.
First, and this is a biggie, it doesn’t consider other types of debt like mortgages and house loans. So, your debt situation could look much worse when you include those balances as well.
Another major drawback is that it can be challenging to put the rule into practice if you’re still carrying student loan debt. As in my case, I had $150k in student debt and so my monthly payments and debt-to-income ratio were well above the 10/20 rule.
Additionally, if you're on an aggressive debt payment plan and are making paying down more than 10% of your monthly take-home pay, the rule of thumb is less helpful.
FAQs
Here are some common questions about the 10/20 rule.
Why aren’t mortgage loans included in the 10/20 financial plan?
Buying a home is considered an investment. So, mortgages and payments made on housing loans are what some financial experts call ‘good’ debt.
Good debt is a loan that you take out to finance a purchase that you hope will offer a high return on your investment. A common example is borrowing money to pay for your home in the hope that when your mortgage is finally paid off, your home will be worth more than what you paid for it.
This is why the rule primarily focuses on "bad" debt aka consumer debt. It's fine to use this rule as a barometer for managing that debt but I always recommend looking at the whole picture of your debt when coming up with a debt paydown strategy, especially in a high-interest rate environment.
What happens if my debt exceeds 10% of my monthly take-home pay?
Unfortunately, this is more common than you think. Luckily, there are several things you can do to reduce your debts.
The most important thing you should focus on is knocking down all your credit card debts and other high-interest debt.
The best way to do that is to pay more than the minimum required payment for each card. It’ll help chip away at your balance and speed up your progress. As a result, you can then work to prevent further debts from piling up and also help raise your credit score.
You should also work to build up an emergency fund of 1 month of expenses to start to prevent yourself from having to take on more credit card debt.
Does the 10/20 rule apply to everyone?
Generally, the 10/20 rule can be helpful when planning a budget that includes debt. However, it doesn’t apply equally well to everyone or every financial situation.
For example, if you’re still struggling with a high balance on your student loan debt, you’re more than likely to owe more than the recommended 20% of your annual income.
So, if you feel that the debt-to-income ratio of 20% isn’t working for you, don’t fret. You can still keep your debt under control as long as your monthly payments don’t exceed 10% of your monthly after-tax income.
How much can I save if I follow the 10/20 rule?
One of the advantages of using this rule is that it allows you to pay off your loans while keeping your debt to a minimum. Another benefit is that it makes it easier to put some of your monthly income aside for while also covering your living expenses.
Next Steps
Think of the 10/20 rule as a debt roadmap to guide you to better manage your outstanding consumer debt and provide a solid base for your budget plan. Its primary purpose is to boost your awareness of how much consumer debt you can take on according to your income. This way, you can determine how you should prioritize your debt goals with your savings goals.
Now that you have a good sense of your initial debt plan you can head over to the to learn more about setting up the rest of your budget.
