What Exactly is a Debt-to-Income Ratio (+ Why it Matters)
Your debt-to-income ratio (DTI) is one of the most important numbers when it comes to getting a loan. But what exactly is it, and why does your lender care so much about it? A DTI measures how much of your monthly income goes towards debt payments. The higher your DTI, the more risk you pose to the lender, and the less likely you are to be approved for a loan.
There are a few ways to lower your DTI, but it’s important to understand how this number is calculated to make the most impact. Read on to learn what it is, and how to calculate DTI. Let’s dive into how lenders use this figure to decide if you’re worth the risk of giving out a loan.
What is Debt-to-Income Ratio?
Debt-to-income ratio refers to how many monthly debt obligations you have compared to your monthly income. As the name implies, the debt portion breaks down how much debt you have after taking out a loan for your business. The income portion shows how much money you are currently bringing in through sales or other sources each month.
The two numbers are then divided by each other to find an overall percentage of how much your debt outweighs the money you make every month.
Why Lenders Care About Debt-to-Income Ratio
Your debt-to-income ratio indicates how likely you are to repay a business loan and make timely payments of the full amount due.
Someone with excessive amounts of personal debt, such as overspending on credit cards, car loans, and other forms of consumer debt, may have a hard time repaying their business loan. This can be due to their income not being enough to cover how much they spend in total (including debt payments) every month. For this reason, it’s good for lenders to know how well you can make debt repayments if they give you a large sum of cash.
Debt-to-Income Ratio Formula
As a quick preface, the debt-to-income ratio is how much debt you have compared to how much income you have coming in each month. This is how it looks as a formula:
Total of Debt Payments per Month ÷ Gross Monthly Income = DTI
This number is how lenders measure how much risk they are taking on when lending you money. If your debt-to-income ratio is high, it means that you will have less disposable income for you to use however you want after paying back the loan.
It can also mean that there are not enough future earnings for them to see a return on their investment. It’s the last thing they want as a lender, so the debt-to-income ratio formula is something they look at closely when underwriting your business loan application.
How To Calculate DTI
To find out how much debt you have compared to how much monthly income you make, start with how much debt you have currently accrued and then subtract any cash or assets you own (other than what is used to run your business) from that number.
You should include mortgage, property loan, credit card, student loan debts as well as any other debt you may have on the books right now.
Next, you’ll want to add how much money you make in a month from your business or other sources. This includes monthly income from a job, Social Security, and tax refunds. The figure should not include any salary that someone else earns for you, like what an employee receives from their employer or what interest rate payments on debt may be categorized under.
Here is a debt-to-income ratio formula example:
If you pay $300 on car loans, $350 on credit cards, and $1,200 in rent per month, your total monthly debt commitment would be $1,850. If you make $60,000 annually, your monthly gross income would be $60,000 divided by 12 months, or $5,000. Your DTI would then be:
$1,850 / $5,000 = 0.37 x 100 = 37%
What Is A Good Debt-To-Income Ratio?
In general, lenders look for a DTI lower than 36% and with no more than 28% of debt assigned to rent or mortgage payments. The maximum ratio to get approved for a loan varies per lender. The lower your DTI is, the better the chances that you will get approval or at least be considered for a credit application.
How To Lower Your Debt-To-Income Ratio
If you’re looking to lower your debt-to-income ratio, the best thing that you can do is pay down the debt you have and build your business credit. As mentioned, any money spent on debt will go towards how much cash lenders may need from you in the future when they give you a business loan.
The more disposable income that lenders see after making your debt repayments, the better off your chances are of getting approved for a small business loan.
If your debt-to-income ratio is close to or higher than 36%, you may want to take steps to reduce it. To do so, you could:
- Pay down the debt you owe
- Increase your monthly income through your business or another source
- Avoid getting into more debt
- Postpone making large purchases
- Regularly compute your debt-to-income ratio to see if you’re making progress
Increase Your Earning Potential With LendThrive’s Help
If you’ve been looking into how to get a loan, how much debt you have is one of several things that lenders will need to know. They’ll ask how much money your business brings in each month from sales and how many customers you have.
This is where LendThrive comes in — we want to help give small businesses more purchasing power through our fixed rate business loans so you can become better equipped at lowering your debt-to-income ratio over time.
Let’s work together on scaling your earning potential so you can pay your debts and bring your debt-to-income ratio down. Talk to our expert advisors at LendThrive today.
