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When you’re looking to get a business loan, a major aspect lender will look at is your debt to income ratio. Of course, you may already know credit scores are an important factor, but that doesn’t give lenders the whole picture. A business’s debt to income ratio is a vital piece of the business funding puzzle because it’s a strong indicator of a business’s overall financial health. Since it’s critical to your approval on a loan application, it’s important to know how to calculate your debt to income ratio. Read on to learn how to do this with and without a debt to income ratio calculator to maximize your chances of obtaining funding.
First Off, What is a Debt to Income Ratio (DTI)?
The debt to income (DTI) ratio refers to the percentage of your business’s gross monthly income that goes toward making monthly debt payments. Lenders use this ratio to determine the level of risk associated with each borrower. At its heart, it’s a comparison of the monthly income a business generates versus its monthly debt expenses.
A DTI of 43% is usually the highest ratio a borrower can have while still qualifying for a loan. Lenders typically deal with ratios of no more than 36%. Additionally, lenders prefer that no more than 28% of that debt goes to rent or mortgage payments. Maximum DTI ratios will vary across lenders. However, in general, the lower the DTI, the higher the chance of approval.
What factors come into play?
More established companies will use a business debt to income ratio known as the Debt Service Coverage Ratio (DSCR). However, newer businesses may not have a DSCR, or they may have one that isn’t ideal. In these cases, small businesses can still apply for loans. Instead of using a DSCR, the lender is likely to ask for the business owner’s debt-to-income ratio. Some lenders will review both personal and business debts.
The DTI ratio does not distinguish between various types of debt or the cost of servicing that debt. For example, a credit card may have higher interest rates than an equipment loan. But when calculating a DTI ratio, the two are lumped together. Switching from a higher interest rate credit card to a lower interest rate card may decrease monthly payments. This affects the DTI ratio, even though the total outstanding debt would remain the same. Due to these varying circumstances, it’s a good idea to always pay attention to interest rates when signing up for any kind of financial assistance.
How to Calculate Your Debt to Income Ratio
The debt to income ratio compares a business’s monthly debt payments to its monthly gross income. Gross income refers to revenue before taxes and other deductions. Calculating a business’s DTI can help to determine how manageable its current debt truly is. As a business owner, it can also help you decide whether applying for additional credit is in your best financial interest.
Lenders use a business’s DTI ratio to measure how capable it is of managing monthly payments and repaying its debts. To calculate a business’s DTI ratio, you first need to know the gross monthly income. To determine gross monthly income, simply take the annual gross income (before taxes) and divide it by 12. Then to calculate the DTI ratio take the business’ total monthly debt payments and divide it by the business’ gross monthly income (pre-taxes). This will give a decimal that simply needs to be multiplied by 100, resulting in the DTI percentage.
Monthly debt payments include credit cards (using the minimum monthly payment), loans, and rent or mortgage payments. Monthly subscriptions as well as similar expenses that can be terminated at any time are not included in the DTI calculation. Typically, payments for utilities (water, garbage, gas, electricity, etc.) do not need to be included when calculating the DTI ratio.
Using a ratio calculator
Different lenders have different requirements for their specific DTI ratio calculations. Many lenders provide their own debt to income ratio calculators. In this case, the business owner enters the amounts into each section and the ratio calculator computes their DTI ratio on its own. If you’re not ready to commit to a lender, there are also online tools like free debt to income ratio calculators. It’s important to look at every lender’s terms and conditions when calculating a DTI ratio, as it may vary across lenders.
Understanding Your Debt to Income Ratio
The DTI indicates the stability of the business. The DTI ratio is all about how much a business owes versus how much it earns every month. If a business has a DTI ratio of 20%, that means that 20% of the business’ monthly gross income goes toward debt payments. However, it should be noted that the DTI ratio does not affect a business’s credit score.
A low DTI ratio makes a borrower more attractive to lenders. Lower DTIs suggest an ample monthly income compared to monthly debt payments. Having a healthy balance between debt and income is ideal for any business.
A high ratio alerts lenders that a borrower has too much debt for the income they earn each month. With a high ratio, there is a greater risk that a borrower won’t be able to maintain making more monthly payments to their lender. The DTI ratio is not the only figure lenders use to decide whether to approve a borrower, but it’s an important one. if you have a less than desirable ratio, you’re not out of luck yet. To reduce your business’s DTI ratio, you will either need to increase monthly revenue or reduce your monthly debt payments.
What is considered a good DTI?
As mentioned, lenders generally consider a DTI of 35% or less to be favorable. This indicates that a business’s debt is manageable and has money left over after paying all its monthly bills. 36% to 49% is typically considered an adequate DTI. There is room for improvement, but there is still a chance of obtaining a loan. Lenders may ask for additional eligibility requirements to approve the business for a loan as the risk here is greater. A DTI ratio of 50% or higher indicates a business has limited money for savings or expenses. This is worrisome if a business experiences unforeseen expenses and signals that a business may be unable to manage any additional monthly payments. With a DTI ratio this high, more than half of the monthly income is going towards debts, and it is, therefore, unlikely to secure a loan.
The debt ratio will show the lender whether or not the business already has loans and how its credit finances compare to its assets. Businesses must make debt payments regardless of profits. Therefore, the DTI helps lenders determine the risk of the borrower. It also helps borrowers determine whether or not taking on more financial debt will be a good business decision.