20/10: The Key to Controlling Your Finances

Getting a new loan or using an additional credit card may seem like a quick solution to meet daily needs or fulfill some desires, but accumulating financial obligations gradually turns into a burden that consumes a large part of income, reduces the ability to save and invest, and even affects quality of life and long-term financial stability.

Amid rising living costs and increasing reliance on consumer financing, the 20/10 rule emerges as one of the simplest tools that helps individuals assess their financial situation and set clear borrowing limits, ensuring budget balance and avoiding falling into a debt spiral.

Consumer Debt

This rule is based on a simple principle: consumer debt should not exceed 20% of annual net income, and monthly installments for such debt should not exceed 10% of monthly net income.

Despite its simplicity, this formula provides a practical indicator that anyone can use to see whether their financial obligations are still within safe limits.

The rule is divided into two main parts: the first concerns total debt, meaning the sum of consumer debt should not exceed one-fifth of annual net income.

The second part focuses on monthly cash flow, so that debt installments do not take up more than a tenth of the salary or monthly net income, leaving enough room for essential expenses, savings, and emergency preparedness.

To apply this rule, an individual only needs to perform two simple calculations. First, determine their monthly net income after taxes or any mandatory deductions, then multiply that number by 10% to find the maximum monthly amount to allocate for consumer debt repayment. If monthly net income is five thousand riyals, the safe limit for monthly installments would be only 500 riyals.

Then, calculate the maximum total debt by multiplying monthly net income by 12 to get annual income, then multiply the result by 20%. In the previous example, annual net income is 60,000 riyals, so total consumer debt should not exceed 12,000 riyals.

Financial Obligations

When financial obligations exceed these limits, it indicates that a large portion of income goes to debt repayment instead of essential spending, savings, or investment, which increases financial pressure and limits flexibility in facing emergencies or unexpected crises.

The importance of the 20/10 rule is not limited to measuring debt size; it also provides a framework to help individuals make more disciplined financial decisions before borrowing. When considering buying a car, using a new credit card, or getting a consumer loan, this rule can be used to determine whether the new payments will remain within acceptable limits or if they will burden the budget further.

The rule also helps set clear goals for gradually reducing debt, as a person can compare their current situation with the suggested limits and work to lower their obligations until they return to a level that ensures greater financial stability. This provides a clearer vision for managing expenses and rearranging financial priorities.

Borrowing Ceiling

One of the most notable advantages of this rule is that it imposes a clear borrowing ceiling, which reduces the likelihood of overusing credit cards or repeatedly resorting to personal loans. Additionally, having a specific numerical standard makes it easier to monitor the financial situation and make more rational decisions away from impulsiveness or the desire for immediate spending.

These practices positively reflect on overall financial health, as lower debt improves the ability to save, reduces the psychological stress associated with financial obligations, and supports the credit rating, which largely depends on the level of indebtedness and payment regularity.

Despite these benefits, the 20/10 rule is not suitable for all cases, as there are circumstances that make compliance difficult or impractical, especially for some groups that bear large financial obligations early in their professional or educational life.

Mortgage

One of the main criticisms of this rule is that it does not include mortgage installments or rents within the debt ratio, but limits itself to consumer debt such as credit cards, car loans, personal loans, and similar financing.

This is because housing is considered a basic need, not consumer debt.

In contrast, financial institutions use different criteria when granting mortgages, often allowing total monthly obligations to reach around 43% of monthly income, a much higher percentage than the limit proposed by the 20/10 rule for consumer debt.

Financial experts believe that the 20/10 rule should be treated as a guideline rather than a binding law, as financial circumstances vary from person to person, as do income levels, living costs, and family needs, requiring some flexibility in its application.

A More Comprehensive Budget

In contrast, there is another financial rule known as the 70/20/10 rule, which deals with the budget more comprehensively, as it does not focus only on debt size, but distributes the entire income between spending, saving, and financial obligations.

According to this rule, about 70% of net income is allocated to living expenses, including food, housing, transportation, insurance, and daily expenses; 20% goes to savings and investment, whether to build an emergency fund, save for retirement, fund children's education, or achieve future financial goals; while only 10% is allocated to repaying consumer debt.

Financial Discipline

Both rules share the goal of limiting borrowing and promoting financial discipline, but the main difference is that the 20/10 rule focuses exclusively on debt, while the 70/20/10 rule provides an integrated view of how to distribute monthly income across various spending and saving categories.

Choosing the most suitable system depends on the nature of income and personal obligations. Some may find the 20/10 rule more appropriate when assessing their borrowing capacity, while others prefer the 70/20/10 rule because it helps them manage their entire budget.

In any case, exceeding the limits suggested by the 20/10 rule does not necessarily mean falling into a financial crisis, but it is an indicator worth noting and calls for reevaluating spending and borrowing patterns. If debt becomes a burden that is difficult to control, it is best to seek financial advice and not wait until the problem worsens.

Thus, successful debt management rests on a simple principle: borrow only when necessary, and commit to limits that can be borne without affecting quality of life or future financial goals. The 20/10 rule is an easy-to-apply tool that gives individuals a clear indicator of the health of their financial situation and encourages them to make more balanced decisions, ensuring financial stability and building a more secure future.

Source: The Balance Money

Important Information

World of Investment and Stock Exchange

{{displayname}}

{{profession}}