Calculating and Managing Your Small Business Debt-to-income Ratio – A Complete Guide
You want your income to be as far above your expenses as possible, but how close is too close? Do you know how your numbers compare?
The most useful metric you can use is your debt-to-income ratio, also known as your DTI. It's relatively simple to calculate; you just add up your monthly debt payments and divide them by your monthly income before deductions.
Example: If you pay $2,000 toward your mortgage, $150 toward your car loan, and $300 toward your credit card debts every month, your total debt payment is $2,450. You don't count utility bills or other non-accumulating expenses. If you make $7,000 a month before taxes, you divide $2,450 by $7,000 and get 0.35. That translates to a debt-to-income ratio of 35 percent.
Small business owners and the debt-to-income ratio
When a business borrows money to fund its operations, lenders look at the company's solvency. More established companies use a business debt-to-income ratio known as the Debt Service Coverage Ratio, or DSCR, which analyzes the company's income in comparison to debt obligations.
If you have a newer business, you might not have a DSCR, or your DSCR might not be where you want it to be yet. You can still apply for a small business loan, but the lender is likely to ask for your personal debt-to-income ratio.
What is a good debt-to-income ratio for small business owners?
You're best off if your DTI is 35 percent or below. That's largely because of the 28/36 rule, which suggests that a household should spend no more than 28 percent of its gross monthly income on housing costs and no more than 36 percent on debt payments.
If your DTI is between 36 and 49, you might still be able to get a loan, but you'll probably have to submit extra documentation such as a credit report or proof of income. Even with these documents, however, you're unlikely to get a loan if your repayment would bring your debt-to-income ratio above 50 percent.
How do you lower your debt-to-income ratio?
If your DTI is too high to qualify you for a desirable interest rate or to get you a loan at all, don't give up! You can lower it, either by increasing your income or decreasing your debt load.
Increasing your income
Making more money is definitely easier said than done, especially if you're a small business owner. You're probably already doing everything you can to raise your revenue, so what else is out there for you? Similarly, if your business isn't off the ground yet, how can you bring in some money?
You could get a part-time job, but you often have to have it for two years before lenders will consider it to be income. The same goes for a side hustle. If you want to increase your calculated income, you have the best chance for success if you have a W2 job and can get a raise.
Decreasing your debt
Paying off debt tends to be easier than generating more income, but it still takes discipline. You'll need to calculate your total monthly income and expenses, then subtract the latter from the former to find out how much you have left over. As much of that as possible should go toward paying off your debts.
There are a number of ways you can go about doing this.
1. The snowball method
This strategy tends to work best for people who want to see tangible results quickly. To pay off your debts, you pay the minimum on each bill and use the remainder to pay off your smallest debt. Once that's paid off, your next smallest becomes your priority, and so on until all of your debts are gone.
2. The avalanche method
This strategy works similarly to the snowball method except that instead of paying off your smallest bill first, you prioritize the account with the highest interest rate.
You'd likely see the number of your bills disappear more slowly with the avalanche method, but you'd also probably end up paying less overall. That's because as you pay off your high interest rate debts, you're accumulating less in interest every month.
3. The bill-to-balance method
If your primary goal in paying off debt is to lower your DTI, the bill-to-balance strategy might be your best bet. The basic structure is similar to the snowball and avalanche method, but your priority is the debt in which the monthly payment is the largest percentage of the balance.
Example: You have two credit cards and a car loan. Each month, you pay $150 toward your $5,000 loan balance as well as $25 on your $300 card balance and $40 on your $200 card balance. The $40 payment makes up the highest percentage of the individual card balance, so paying that off would lower your DTI most quickly.
4. Tapping your home equity
If you're a homeowner, you can tap the equity you've built to reduce your debt load and improve your DTI. Again, there are a few ways you can go about doing so.
Take out a home equity loan or HELOC
A home equity loan and a home equity line of credit, or HELOC, both allow you to borrow against your equity. You get cash equal to a percentage of the equity you've built up, and you pay that back to the bank with interest. If you have enough equity, this can be an effective way of consolidating your debts into one easier-to-manage monthly payment.
That said, both a HELOC and a home equity loan use your home as collateral. If you default, you could lose your property.
Sell and move
If you don't want to get caught up in another borrowing arrangement, you can try to sell your home and relocate. You don't have a loan to pay back, but you do have the expense of finding a new place to live and moving into it.
Sell and Stay
Thanks to EasyKnock, there is another option. Sell and Stay allows you to sell your home and receive the equity but stay in place as a tenant, paying rent to EasyKnock until you choose to repurchase your home or relocate.
With this option, you get the best of both worlds. It's not a loan, so you don't have to have a low DTI, nor do you have another debt to pay back. And you can use the cash you receive to pay back other debts and get your small business debt-to-income ratio under control.
- Debt-to-income ratio (DTI) is what lenders use to determine if you can afford a new loan. To find it, divide your monthly debt payments by your gross monthly income.
- If your DTI is above 35 you may have trouble getting a loan. You definitely will have trouble if it’s above 50.
- You can lower your debt-to-income ratio by growing your income or paying off debts.
- EasyKnock's Sell and Stay program is a safe and flexible way of tapping your equity and repaying debts. Learn more by reaching out today.