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How To Calculate Your Debt To Income Ratio

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Entrepreneurs often face a dilemma when they are deciding how much to borrow for their businesses. If you borrow too little, you may not have enough cash to meet your needs. But if you take on excess debt, you may be unable to meet your repayment obligations. 

Is there any way to calculate the ideal level of debt for your company? 

Fortunately, there is. Your debt to income ratio can help you to determine your borrowing limit.

This article discusses what the debt to income ratio is, the formula to calculate it, as well as some tips to get a better ratio.

What is the debt to income ratio?

Your debt to income ratio tells you the proportion of your monthly income that goes towards paying your debt. It is usually calculated as a percentage.

The procedure for calculating this ratio involves knowing:

  1. Your total monthly debt repayment obligation.
  2. Your monthly gross income.

Some lenders check the applicant’s debt to income ratio before approving a loan. A low ratio is considered favorably by lenders. 

It tells them that you would be in a position to repay the sum you have borrowed. However, a high debt to income ratio sends the opposite message: a lender would think twice before advancing funds.

How to calculate debt to income ratio

This is the debt to income ratio formula:

Debt to income ratio = Total monthly debt payments ➗ Total gross monthly income

You will arrive at your debt to income ratio. If you multiply this ratio by 100, it will give you the relevant percentage.

Let’s understand how the debt to income ratio is calculated with the help of an example.

Camila, who runs a small restaurant, has borrowed money from an online lender to pay for new kitchen equipment. She can calculate her debt to income ratio by using the following information about her business:

Camila’s total monthly debt payments: $2,000

Gross monthly income of the restaurant: $6,000

Debt to income ratio = ($2,000 ➗ $6,000) ✖️ 100 = 33%

This calculation tells Camila that one-third of her monthly revenue is going towards meeting her debt payments. 

In the Cafe Beautiful Hispanic Woman Makes Takeaway Coffee For a Customer Who Pays by Contactless Mobile Phone to Credit Card System. Concept: debt to income ratio

Is Camila’s debt to income ratio at an acceptable level? Let’s find out. 

What is a good debt to income ratio?

As a general rule, a lower ratio is considered to be better. A ratio of, say, 10%, would indicate that only one-tenth of the available funds are being used for debt repayments. However, if the ratio were higher at, say, 60%, it could be a sign of over-borrowing. 

If 60% of a business’s gross income were being used for repaying debt, it would leave very little money for other expenses.

A ratio that is at or below 36% is considered acceptable. A low ratio indicates that you can borrow more. However, if the ratio is high, you should focus on ways to reduce it rather than taking on more debt.

Here’s a table that illustrates how lenders would interpret your debt to income ratio:

Debt to income ratio percentages

Benchmark level measure. Set of gauge score with red, green and yellow tables. concept: debt to income ratio

10% – A comfortable ratio. You shouldn’t have a problem raising funds provided you meet the lender’s other requirements.

20% – This is also a good ratio. It should be easy to raise more money for your business.

36% – You’re at your borrowing limit. If you need more funds, you would need to convince the lender that you will be in a position to repay.

40% – It could be difficult to get a positive response to your loan application. But don’t give up. You could find a lender that is willing to advance funds.

50% or more – It’s probably advisable not to borrow anymore. Instead, you should focus on improving your debt to income ratio.

How to fix a bad debt to income ratio

What if you have a poor debt to income ratio and your business requires funds? How will you raise the money you need?

There are several ways in which you can overcome this problem. 

1. Lower your borrowing cost 

In an earlier section of this post, the method for calculation of the debt to income ratio was explained. Let’s revisit the formula:

Debt to income ratio = Total monthly debt payments ➗ Total gross monthly income

You’ll notice that a higher “Total monthly debt payments” amount will result in a greater debt to income ratio. If you lower your existing borrowing costs, you can reduce the amount that you pay towards loan repayments every month.

How can you bring down your borrowing costs? 

One way to do this is to use a business loan as a debt consolidation loan. This involves paying off your existing high-cost debt by taking a new loan. Remember that this method works only if the debt consolidation loan carries a rate of interest that is lower than your current rate. 

At Camino Financial we offer small business loans at rates ranging from 12% to 24.75%. If you are currently paying more than this, one of our loans could be the way to go. This could help you to slash your borrowing costs and boost your profits. 

Young Hispanic couple smiling to camera outside their shop. Concept: debt to income ratio

2. Don’t deploy your funds in assets that provide a poor return on investment 

Some business owners can be overly optimistic when it comes to calculating the profitability of a new investment. They make the mistake of over-estimating the revenue that they will generate and under-estimating the costs.

If you fall into this trap, you will earn a lower than expected return on investment (ROI). The profit may not be even enough to repay the loan that you have taken. 

What should you do if you find yourself in this situation? 

Carry out a careful review of the revenue that your assets are generating and the profits that you make from them. If an asset is being sub-optimally used or is lying idle, it may make sense to sell it and prepay one of your loans.

3. Increase your sales 

Have another look at the debt to income ratio formula. The denominator in the formula is your gross monthly income. If you can increase this amount, your debt to income ratio will fall.

This example will illustrate how this happens:

Scenario 1

Total monthly debt payments: $2,000

Total gross monthly income: $10,000 

Debt to income ratio: 20% 

Scenario 2

Total monthly debt payments: $2,000

Total gross monthly income: $12,000 

Debt to income ratio: 16.7% 

Focus on marketing your product or service. A push in this direction could generate more sales and bring your debt to income ratio under control. As you can see, an increase in the gross monthly income has resulted in a decline in the debt to income ratio.

Increasing your company’s revenue will also provide you with more free cash flow. This will help to improve your bank balance and strengthen your financial position.

4. Improve your credit score 

Many lenders link the rate of interest they charge to your credit score. A higher score gets you a lower rate of interest. 

If your score is at the lower end of the range, you should work towards increasing it. There are several ways to improve your credit score

Debt to income ratio: in real life

To better understand the debt to income ratio, let’s take a look at an example:

Tomás is the proprietor of a small construction firm. A few months ago, he had the opportunity to bid for a large contract. However, one of the prerequisites was that the bidder needed to be the owner of a specific type of equipment. 

Although Tomás knew that he might not win the contract, he went ahead and bought the machinery with a loan from his bank.

The monthly installment for the new equipment was $3,000. In addition to this, Tomás had to pay $1,000 per month to other lenders for his existing loans. 

Unfortunately, Tomás was not awarded the contract. The machinery that he bought could not be used.

Here is the debt to income ratio calculation both before and after the new loan:

Debt to income ratio calculation before the new loan Debt to income ratio calculation after the new loan
Total monthly debt payments $1,000 $4,000 ($1,000 for the old loans ➕ $3,000 for the new loan)
Total gross monthly income $7,000 $7,000
Debt to income ratio calculation ($1,000 ➗ $7,000) ✖️ 100 = 14% ($4,000➗ $7,000) ✖️ 100 = 57%
Debt to income ratio 14% 57%

You can see that the debt to income ratio has shot up from a comfortable 14% to an unsustainable 57%. 

Tomás started paying the bank’s loan installments from his savings. However, he realized that he couldn’t afford this for very long. After giving the matter a lot of thought, he decided to sell the equipment at a loss and repay the bank’s loan. 

When the transaction was complete, his debt to income ratio came back to its original level of 14%. 

Tomás promised himself that, in the future, he would make new investments only if he was sure that they would provide him with an adequate return.

Young engineer holding contract. Concept: debt to income ratio

What is your debt to income ratio?

The debt to income ratio formula can be a useful tool to help you to decide how much you should borrow. If your ratio is above 36%, try and work on reducing it. This will increase the chances of your loan application being approved. 

At Camino Financial we provide small business loans for sums up to $400,000. Our loan approval norms and procedures are guided by our philosophy of “No business left behind.” This ensures that your loan application will be examined carefully and that we will do our best to provide your business with the funds it needs.

Request a quote for a business loan today. Our form takes only a few minutes to complete, and a loan from us could give you the money you need to grow your business and take it to the next level.

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