How can you figure out if you can afford a loan? How do lenders determine if you can handle the monthly payments? Both of these questions often come down to understanding your debt-to-income ratio (DTI).
Your credit score and a few other business health indicators largely determine how much debt you can handle. So what is a good debt ratio to get the funds you need?
Below, you’ll learn what a good debt ratio looks like, how to calculate your own debt-to-income ratio, what it means to lenders and your business, and how you can improve it. Let’s begin with what a debt-to-income ratio is and what an ideal debt to income ratio looks like.
What Is Debt-to-Income Ratio?
Debt-to-income ratio (or debt-to-revenue ratio) is a percentage of your monthly debt payments divided by your monthly gross income. This measures your ability to take on, and pay, additional debt. When you apply for a mortgage or a business loan, your lender analyzes your DTI—along with other application factors—before deciding whether to present you with a loan offer. In essence, the lower your DTI, the easier it will be for you to receive an approval.
DTI ratios are a good indicator of how effectively you manage your debts and spend your money, each month. You don’t need to have a high income to have a low DTI ratio; debt-to-income is a measure of how effectively you manage your money, not wealth.
When lenders calculate your DTI, they will occasionally break out their measurements by the front-end or the back-end. A front-end debt-to-income ratio is calculated using only your housing expenses like your mortgage or rent payments. For homeowners, your property taxes and homeowners insurance will also be factored in. The other break out is known as a back-end debt-to-income ratio, which includes credit card payments, child support and any other loan payments. While each of these is important to the overall debt-to-income ratio, financial professionals believe back-end debt-to-income ratio is more important when applying for a major loan, like a mortgage.
What is a Good Debt-to-Income Ratio?
The ideal debt-to-income ratio is anything at or below 35%. A percentage in this range is considered good by most lenders, since you’re more likely to make your regularly scheduled loan payment each month. There are three primary debt-to-income ratios benchmarks you need to be aware of:
|Under 36% (Good)||This is a very healthy debt to income ratio. Your debt, compared to your income, is quite manageable. In this range, your likelihood of approval is high.|
|36% – 49% (Okay)||In this range, lenders view your DTI as potentially becoming unmanageable. While there is room for improvement, it could be enough to secure a loan.|
|Above 49% (Unacceptable)||With more than half of your income going toward debt payments, it is difficult for you to save money or deal with unexpected expenses. Securing a loan will be challenging.|
While this table is representative of the majority of DTI ratio standards, there are limits to these categories. Each company will have their own standards depending on the type of loan you’re applying for. For example, some lenders won’t make a business loan if your DTI is higher than 43%. Other lenders focus on calculating DTI without your mortgage or rent payments, meaning they’re looking for a ratio that excludes those major payments but would still come in at or under 25%.
How to Calculate Your Debt-to-Income Ratio
Calculating DTI starts by dividing your monthly payments over your gross monthly income:
DTI = Total of Monthly Debt Payments/Gross Monthly Income
While the formula for calculating DTI is straightforward, to get the correct ratio, you need to make sure you’re working with complete data. Here’s what those variables should include:
Total Monthly Debt Payments
Your total monthly debt payments cover any installment of a debt obligation. These payments commonly include your minimum credit card payments, mortgage, personal, student, and car loan installments, along with any real estate taxes and homeowner’s insurance.
Monthly subscriptions and similar expenses that can be terminated at any time are not included in your total monthly payments. Variable regular expenses like utilities, groceries and gas are also not generally included.
Total Gross Monthly Income
Your gross monthly income is the total amount of income you earn in one month before taxes and other deductions. To estimate your gross monthly income, take your annual salary, along with any other sources of revenue, and divide by 12.
Total Gross Monthly Income = Annual Income/12
Your income sources can include business revenue, salary, sales commissions, overtime pay, investment dividends and social security payments. It’s important to note that lenders will usually only consider non-W2 earnings if you’re able to provide two years of earnings on your two most recent tax returns.
An Example DTI Calculation
To get a better idea of how calculating DTI looks from start to finish, let’s go through an example together.
In this scenario, your gross monthly income is $8,000 and you have a current monthly debt payment of $750. Given the information, your current debt to income ratio is calculated as follows:
($750) / $8,000 = 9.375% DTI
You’re looking to apply for a $50,000 loan with a new lender, with an amortized monthly payment of $1,500. As part of the assessment process, the lender will estimate your new debt to income ratio by adding the anticipated $1,500 debt payment to your current $750 debt payment:
($750) + ($1,500) / $8,000 = 28.125% DTI
With a DTI of just over 28%, you would more than likely be approved for the $50,000 loan in this example. With such a low DTI, it’s possible your new lender may pre-approve you for a loan amount equal to a $3,000 monthly payment, which would be just shy of a 50% DTI ratio, the maximum for most lenders.
Lowering Your Business Debt-to-Income Balance
Keeping your debt-to-income ratio low doesn’t only help secure the best loans for your small business. By lowering your DTI, you have the ability to raise your credit score, be approved for higher loan amounts and take on more than one loan—with lower interest rates—at a time. Of course, a lower debt-to-income ratio doesn’t mean you need to take on additional debt obligations, it simply means you have the capacity to manage debt without incurring significant financial distress.
Lowering your DTI equals more financial breathing room. This is easier said than done, but it is possible. Here are four ways you can reduce your DTI:
1. Don’t Take Out Additional Loans Right Away
Before you take on any new loans, work on paying off the debt you’ve already assumed. New loans will only increase your monthly obligations and, thus, your DTI ratio. Develop a system that allows you to methodically pay down any existing credit card, student or housing debts before applying for other financing.
2. Consolidate Your Debts
A debt consolidation loan can help you pay off your debts faster than you may be able to on your own. Consolidating may result in a higher DTI ratio initially, but as you make payments, you’ll lower your ratio and pay off your debts faster. Another benefit is that you may be able to get better terms and rates by consolidating.
3. Refinance Existing Debts
When debt becomes unmanageable, it’s worth exploring every option, including renegotiating with your lender. The benefit of refinancing your debt—beyond the lower rate and monthly payment—is the reduction of your DTI ratio, allowing your business to become a more flexible, financially.
4. Increase Your Revenue
While you may file this into the category of, “easier said than done,” increasing your revenues doesn’t necessarily mean charging your clients more. Additional revenue can be generated by adding a new product line or upselling complementary services that bring additional value to your business. Adding new revenue to your business will help to achieve a good debt ratio, positioning you for greater opportunities in the future.
What DTI Means For Your Business
Business debt-to-income ratios are used to analyze the total financial risk you and your shareholders face. Beyond that, your business debt-to-income ratio should assist you in how you decide to move forward. Ultimately, how you use your debt ratios comes down to your own business goals and how you choose to fund and sustain your growth. Here are two options you can pursue to grow your business:
A low DTI demonstrates a good balance between debt and income, making you a good candidate to take on new debt. Lenders estimate that if you have a small debt-to-income ratio, you’ll be able to successfully manage monthly payments without issue. While new debt will increase your liability and your business debt-to-income ratio, a business loan is a helpful tool to grow your business.
Having a higher DTI can be advantageous if you’re looking to secure outside investment. Investors typically want to buy stock in companies that have increased their operations by leveraging debt. A business in the process of scaling its operations could generate a greater total return for investors.
The Bottom Line on Debt-to-Income Ratios
Carrying high-interest debt that burdens your business for years is never something any business wants. Taking on productive, manageable and revenue-generating debt, however, can be beneficial. Certain industries will always have higher DTI ratios than others, based on the nature of their work. Businesses operating in capital-intensive industries like the transportation and energy fields have a bit more flexibility with their debt ratios as they expand their operations.
A good debt ratio is one that effectively manages and uses debt to improve your business. Keeping your debt manageable—around 36%— is crucial to allowing your business to maintain regular payments, expenses, taxes, savings and overall growth.