Debt-to-Income Ratio: What It Is & How To Calculate It

The debt-to-income (DTI) ratio measures the percentage of your monthly debt payments to your monthly gross income. For example, if your total monthly debt payments are $3,000 and your monthly gross income is $10,000, your DTI ratio is 30%. Lenders check this during the application process. While it’s more commonly used for personal lending, it occasionally is used for business finance when a business has just one owner. Lenders typically require businesses to have a DTI below 50%. However, a DTI below 40% is considered optimal.

How to Calculate the Debt-to-Income Ratio

The formula to calculate the DTI ratio is straightforward:

Total Monthly Recurring Debt Payments

Your total monthly recurring debts represent all of the monthly payments for your current loans. For business loans, this includes commercial real estate loans, lines of credit, equipment leases, business vehicle loans, and minimum business credit card payments.

Lenders may also factor in an applicant’s personal mortgages, home equity loans, lines of credit, personal credit card payments, student loans, personal loans, personal auto loans, real estate taxes, and homeowner’s insurance if business funds are directly used to make these payments.

Variable regular expenses, such as groceries, utilities, and gas, generally aren’t included in monthly recurring debts. Also, monthly subscription plans typically aren’t considered recurring debt because you have the option to terminate these expenses.

Total Gross Monthly Income

With business loans, gross monthly income represents your total gross sales minus the cost of goods sold (COGS). COGS includes items, such as the cost of material, the cost of labor used to produce that product, and shipping costs. Determining a monthly average can be done by using the sum of the last two years of your gross profit and dividing it by 24 months.

For personal income, gross monthly income represents your total monthly income before taxes and other pretax benefits are deducted. This includes income sources like salary and commissions. However, lenders will typically only consider non-W2 earnings, such as 1099, income if you can show two years of earnings on your prior two tax returns.

For example, if you’re a W2 employee who earns a bimonthly paycheck with gross earnings of $5,000, your gross monthly income would be calculated as $5,000 times two, or $10,000. If you also work with clients on the side and recorded on your tax returns $5,000 in year one and $10,000 in year two, lenders will take the lower amount of $6,000 and divide by 12, adding $500 to your total gross monthly income.

Example of a Debt-to-Income Ratio Calculation

As an example of how to calculate your DTI ratio, assume your business has a gross monthly income of $20,000 and an existing monthly debt payment of $4,000. Your DTI ratio would look like this:

($4,000) / $20,000 = 20% DTI

If you then decide to apply for a $100,000 loan, your lender will look at the projected monthly payment for the loan and add it to your existing DTI ratio. When assessing your application, your lender calculates the monthly payment as $2,000. The projected $2,000 debt payment is then added to your existing $4,000 debt payment when calculating your new debt-to-income ratio:

($2,000) + ($4,000) = ($6,000)
(6,000) / $20,000 = 30% DTI

Based on the above example, should you be approved for the new $100,000 loan with monthly payments of $2,000? Theoretically, a lender could preapprove you for a loan amount equal to a $4,000 monthly payment, which would equal a 40% DTI ratio.

Why the Debt-to-Income Ratio Is Important

The debt-to-income ratio is important because it measures your ability to cover loan payments and other debt obligations. Ideally, lenders prefer a DTI ratio for small businesses under 40% and will rarely approve loans for businesses with a DTI ratio over 50%. With personal loans, a DTI ratio under 36% is considered ideal, with lenders rarely approving loans with a DTI ratio over 43%. The lower your DTI ratio is, the better your chances are of getting approved for financing. A lower DTI ratio also is reflective of stable finances.

The DTI ratio is similar to the debt service coverage ratio (DSCR). Both are used by lenders to assess the ability of a person or entity to take on debt. DSCR is more frequently used by lenders for business financing, with DTI ratios typically used in personal lending. However, some business lenders will use DTI calculations in their underwriting.

How to Lower Your Debt-to-Income Ratio

Your debt-to-income ratio measures whether your gross monthly income is sufficient to meet regular monthly debt payments. It’s also a general indicator of your financial solvency. A low debt-to-income ratio is preferable. Four ways to lower your debt-to-income ratio include:

• Consolidate your debt: Bundling your current loans into a single, larger loan with a longer repayment period will lower your DTI ratio as your combined debt obligations may lower. Keep in mind that doing this may cost more in the long run as you pay additional interest over time. If your cash flow supports paying additional on a consolidated loan, do so.
• Refinance higher interest rate loans: If you prefer not to have one large loan payment each month, look at refinancing any loans with high interest rates into lower interest rate products. For example, if you have credit cards with interest rates over 20%, look for credit cards that offer rates that are several percentage points lower.
• Renegotiate lease terms: A business that leases its location can renegotiate into a longer-term lease if the landlord is willing to offer a lower lease rate. This can lower the monthly debt obligation for a business. Also, if you have leased equipment that can be bought out or the terms can be renewed, the ability to pay off your lease or renew it may yield some additional savings.
• Pay off some of your debts faster: This may be tougher to do if you or your business are working with a tight budget. However, if you have debts that are close to being paid off and you can get them eliminated, this can improve your DTI ratio as those payments get eliminated. You may wish to seek out additional financing as part of your loan application with the condition that these debts get paid off.

Bottom Line

The debt-to-income ratio measures the percentage of your monthly debt payments to your monthly gross income. The lower your DTI ratio is, the more likely it’s you’ll be approved for financing. Businesses should strive for a DTI ratio below 40%, with individuals aiming for a DTI ratio below 36%. You can improve your debt-to-income ratio by paying off your debts or refinancing them into lower interest rate loans.