Investment and finance can be intimidating. That's why rules and formulas often encourage us to feel confident that we are on the right track. Unfortunately, sometimes it seems like there are competing rules for every topic, and as an investor, you can cherry-pick the one you want. The same can be said for personal finance rules, although following some common sense guidelines is a wise approach to financial discipline and health.
Many financial experts create rules to help us control budgeting and spending and to help consumers understand what factors contribute to their ability to access certain financial products. It’s helpful for everyone to understand these “rules” and guidelines, even if they aren’t always fully applicable. For example, one well-known rule is the debt-to-income ratios that lenders look at when evaluating the financial condition of a potential borrower. The “front-end” ratio should be no higher than 28 percent, and the “back-end” ratio should be 36 percent or less.
What Do These Ratios Mean?
The front-end ratio is the percentage of your monthly gross income needed to pay your housing obligation (including mortgage, property taxes, homeowners’ insurance, and HOA, if applicable). Lenders prefer that the amount be less than or equal to 28 percent of gross income. To calculate the back-end ratio, you take the housing costs and add other monthly debt payments, like car loans, credit cards, student loans, and even child support.
While these 28 and 36 percent limits on debt to gross income are traditional, lenders often allow higher debt ratios, depending on the applicant’s credit score and income.
What Is the 20/10 Rule For?
The 20/10 credit rule differs from these better-known ratios in several ways. First, it excludes housing costs, considering only other kinds of consumer debt. Second, it compares debt to net income rather than gross income. The gross income is your pay before deductions for taxes and benefits, which may be substantially higher than your net income, which is the amount you have available to pay for things like credit, not to mention food, utilities, gasoline, and other basics. For example, suppose you receive a salary of $10,000 per month, but the amount you receive after the deductions for taxes, health insurance, and a contribution to your 401(k) account is $6,500. So your gross income is $10,000, and your net income is $6,500.
According to the 20/10 rule, you should limit your non-housing debt to twenty percent of your annual net income and keep your monthly payments for that debt to less than ten percent of the monthly net amount. Here is an example using the net amount of $6,500:
$6,500 times twelve months equals an annual net income of $78,000. According to this rule, the consumer should not borrow more than $15,600 or have debt payments higher than $650 per month. That may sound sensible until you consider that the cost of a new car is likely higher than that, even if the consumer has no other debt for student loans, credit cards, or perhaps a consumer account like furniture. Remember that, like most rules, the 20/10 is great advice in theory and may be part of an overall evaluation of whether a particular financial decision is responsible.
