Establishing And Understanding Debt-to-Income Ratio

By: First Union | Date:

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Establishing And Understanding Debt-to-Income Ratio

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Whenever you apply for a loan, the lender is going to look at a number of factors. From the time in business to credit score, to whether or not it seems that you can afford the loan. How do they establish this? They look closely at what is called your debt-to-income ratio (DTI/). Ensuring that your company's DTI is where it needs to be is thus paramount when it comes to preparing your loan application. We've put together a brief guide to help you understand how you arrive at your DTI and if it isn't where it needs to be, what steps you can take to improve it.

Understanding Debt-to-Income Ratio

Essentially you can understand debt-to-income ratio as monthly debts divided by monthly gross income. Depending on where this falls as far as your business is concerned, a lender will be able to tell whether or not you're capable of acquiring any new debt. The rule of thumb: the lower your DTI, the better your chances are of getting approved for your business loan. Not to mention, it tells the potential lender how well you handle and consequently manages debt in general.

So the big question: Where does that ideal DTI fall?

You want to strive to have a DTI below 36%--for most lenders, this would be considered good and thus make you a safer risk as far as any new/future loans are concerned. The ideal debt-to-income ratio is anything at or below 35%. To give you a frame of reference; below 36% is a healthy debt-to-income ratio; 36-49% could be verging on too much debt, though there is still some probability that your application would be approved; above 49% is usually going to be an automatic rejection as this insinuates that more than half of your current income is being used to pay off existing debts.

Calculating Your Debt-to-Income Ratio

The formula for calculating the debt-to-income ratio is not as difficult as you might think.

DTI = Monthly Debt Payments/Gross Monthly Income

Pretty straightforward, as we said. The tricky part, however, is to make sure you have all the relevant numbers you need; meaning, leave nothing out otherwise the DTI could be an inaccurate representation of what you actually have coming in and subsequently going out every month.

Have All Monthly Debt Payments

Make sure you account for absolutely everything here, to include any installment debt, also credit card payments, any mortgage payments, vehicle payments. Also, don't forget basic things such as taxes and insurances. All of this goes toward what you spend every single month paying off what is in essence debt. You do not have to factor in variable expenses such as gas or food.

What is Your Gross Monthly Income

This is going to be what you earn in a month before any relevant deductions or taxes. Income sources can also include bonuses, commissions, investment dividends, and other such revenue.

Once you've figured out both numbers in their totality than simply plug them into the above formula. Where does your DTI stand?

How to Lower Business Debt-to-Income

Let's say the resulting number is not where it needs to be in order to get a loan for your business. Now you are faced with the task of having to bring down the debt-to-income ratio to within the "good" range. How do you do this? What are some crucial steps you can take to lower your DTI and thus have a better shot at approval? If you can lower that DTI, you not only improve your chances of qualification, but you also make things more financially stable for your company. In the long run, a lower DTI is far better for the economic well-being of your organization.

1. Work on Paying Off Existing Debt

Seems pretty simple…before jumping into brand new debt take some time to regroup, refocus and get some of that current debt paid down. Maybe pay a little more than the minimum each month. Focus on those loanscredit cards with higher APRs. If you dive right into more debt, you are only going to see that DTI creep up even more.

2. Consolidate Debts Where Possible

You might want to consider a debt consolidation loan. This will help you pay down debt faster, your interest rate will most likely be lower, and you're now looking at one easy monthly payment, versus several scattered payments that are all over the place.

3. Refinance Current Debts

By refinancing and in essence renegotiating with a lender, you may be able to get a more favorable rate. Not to mention, this could then knock down your monthly payment as well. And with a lower monthly payment, your DTI is accordingly lowered a bit.

4. Boost Revenue

It's not only the debt side of this that you can go after—but remember it's also based on revenue. Focus on ways to increase sales and bring in more money. You may think about a price increase, you could also launch a new product, run a promotion, upsell addendum services/products. Be creative. The more money you make the lower your DTI is.

When it Comes to Business Loans

Whether or not you're a good candidate for a loan is going to depend heavily on your company's DTI. Lenders who see a low DTI are more willing to take the risk. Granted, this new loan will then increase your debt to income ratio but then again you can now use this money to help grow your company and in essence, boost your revenue. Also, keep in mind, if you're looking to attract outside investors, they tend to look favorably on those who use debt to their advantage and thus scale their companies.

The Bottom Line

Carrying too much debt—especially of the high-interest variety—is never a good thing. In fact, it can seriously hinder your company's performance over the long haul. You want to do everything you can to manage that debt effectively and thereby make yourself a viable candidate for the type of business debt that is actually good for the company---debt that helps you move into bigger and better office space, or purchase new equipment, or hire a larger staff. Don't be afraid of debt, but don't let yourself be overwhelmed by it either. There is a fine line here for any company. Shoot for that under 36% mark and put yourself in the most competitive position possible.

Us at First Union want to see your business grow and thrive. We have the funding that can help you from short term loans, merchant cash advances, lines of credit, to equipment financing. Call today!

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