Some say rules are made to be broken, but when it comes to following financial rules and ratios, they can keep your finances in check. Many financial institutions use money ratios to determine whether borrowers qualify for loans. However, you can use other financial rules personally to help you manage your money and debt responsibly. Enter the 10 20 rule.
The 10/20 rule finance ratio can help you stay on the safe side of debt and keep you from living paycheck to paycheck like 61% of Americans do.
This article will answer questions such as “What is the 10/20 rule,” discuss what it is used for, and dive into how to use it to benefit your finances.
What is the 10/20 rule?
So, what is the 10/20 rule finance ratio anyway, and why should you use it? The 10 20 rule (also known as the 20/10 rule) is a simple finance formula that helps you determine how much debt you should have.
With this rule, it is recommended that your total amount of debt, excluding your mortgage, should not be more than 20% of your net income. The 10% portion is the total amount of your net income you should pay monthly towards those debts.
You can keep your debt under control simply by utilizing this formula.
The 10/20 rule vs. the 28/36 rule
You may have heard of different financial rules and formulas being used for lending purposes. The 10 20 rule is a personal finance rule for those that are trying to keep a tight grip on their financial situation and not acquire too much unnecessary debt.
However, the 28/36 rule is a financial ratio that lenders use to determine how much debt you can take on, specifically for homebuyers. This rule states that borrowers should not exceed 28% of their “gross income” for housing expenses, aka mortgage payments, and no more than 36% of their “gross income” should be allocated towards other consumer debt payments.
Consumer debt would consist of credit cards, vehicles, student loans, etc.
Another key difference between the 10/20 rule finance ratio and the 28/36 rule is that you use your net income, and lenders use your gross income. Your net income is your take-home pay after taxes, payroll deductions, and benefits.
It’s essential that you use this for your 10/20 rule guide because it can make a huge difference in what you can really afford!
For instance, if your gross income is $35,000 a year, you may reason that you could comfortably afford a debt load of $7,000. But if your net income is closer to something like $28,000 a year, your total debt should really not be more than $5,600 according to the 10 20 rule.
How to use the 10/20 rule finance ratio
To start using the 10 20 rule is calculate your monthly net income and multiply that by 10%. This will show you how much per month you should be paying towards debt.
For instance, if your net income is $3,500 per month, you multiply that by 10%, which equals $350 a month.
Next, multiply your net monthly income by 12 to calculate your annual salary. Then multiply that by 20% to figure out the maximum amount of debt you should carry. So, $3,500 x 12 equals $42,000.00 x 20% is $8,400.
So, according to the 10/20 rule, you should not exceed more than $8,400 in consumer debt.
Using this simple method can prevent you from taking on too much debt and keep you on track to financial success.
Pros and Cons of the 10/20 rule
There are always pros and cons to everything. Here are some things to keep in mind when using this formula.
- It prevents you from overloading yourself with consumer debt.
- It’s simple to follow.
- It gives you a monthly breakdown of how much you should be allocating to your debt.
- Student loans can make reaching the 20% threshold difficult.
- The 10/20 rule finance ratio does not include mortgage payments. (This can cause you to be unaware of how costly your living expenses are.)
What if your debt exceeds the 10/20 rule?
Did the calculations for your debt not go so well? What should you do if you are over the 20% limit? Don’t panic; many of us have been in this situation.
The first thing you should do is create a debt reduction plan to knock out your debt faster. Creating a plan to reduce debt can help you budget your money better. It can also save you money by paying off high-interest loans quicker.
Two of the most popular debt payoff methods are “The Avalanche Method” and “The Debt Snowball Method.” Here is a breakdown of each method so you can choose which one will work best for you.
The Avalanche Method
The avalanche method is where you pay the debt with the highest interest first. This is a great way to save money. You could save thousands of dollars in interest using the Avalanche Method.
So if you have a high-interest credit card, you would focus on paying additional payments toward the balance to knock down your most expensive debt first.
Use a credit card payoff calculator to determine how much interest you could save by paying them off sooner.
Debt Snowball Method
The debt snowball method is excellent if you find it hard to stay motivated to pay off debt. This method works by paying off your smallest debt first as quickly as you can.
After you pay off your first loan, you move on to the next smallest debt, applying the amount from the paid-off balance to the next one, so you pay it off faster.
For example, let’s say you have three credit cards you owe money on. The amounts are $500, $1,200, and $2,000. You would pay off the $500 first by making additional payments to the balance, then move on to the $1,200 balance and apply what you were paying on the previous debt to the new debt.
This causes a “snowball effect” because it’s like a snowball rolling down the hill, gaining momentum, and before you know it, you are debt free.
However, this strategy is more costly because the bigger balances could have a higher interest rate. This means you will end up paying more money for your debt over time.
Both strategies are fantastic for paying debt down more efficiently. The main thing is that you choose a strategy that is easy for you to stick to.
Consolidate your debt with our help
Another option is consolidating your debt into one easy payment. Of course, you want to be sure you roll it into a lower interest rate so you can save money too.
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Use the 10/20 rule to control your debt!
Having excessive debt can cause stress and financial strain. You can avoid falling into unaffordable debt by using the 10 20 rule.
It’s easy to use, and even if you are over the 20% threshold, you can use a debt payoff method or consolidate your debt into one of our low-interest personal loans.
So, start using the 10/20 rule to keep your finances in check and debt at bay!