What’s worse than being in desperate need of a business loan only to be denied because your debt service coverage ratio is too high? Not knowing what it is at all! It’s hard enough to pull together all the information and fill out forms to get a business loan. But no lender will gladly dole out money without understanding your ability to pay it back. That’s why it’s imperative you understand your debt service coverage ratio now and in the future.
So what exactly is a debt service coverage ratio? Simply put – a ratio of your debt to your total income. Debts are anything that is an ongoing expense such as mortgage, HOA fees, insurance, etc. The ratios fall into two broad types:
Gross Debt Service Ratio (GDS)
All ongoing expenses except for any payments on loans, cars, credit cards, alimony, etc. / Total Income * 100
Total Debt Service Ratio (TDS)
All ongoing expenses and debts payments / Total Income * 100
Lenders will use these ratios to determine the likelihood of you being able to pay back your loan. Ideally, you want to have a GDS under 30%. Even being above this number by a small amount can limit your options. TDS will need to come in under 40%. Keep in mind that these are just guidelines. However, they are good starting points to work with.
It’s also worth noting that the payments determine the ratio, not the total debt. If you have an outstanding loan for $1,000 that you pay $50 a month on or one that is $10,000 you pay $50 a month on, paying off your $1,000 to eliminate the $50 monthly payment will immediately improve your ratio.
Let’s consider an example. Carlos Fuentes owns an auto body shop and is looking to take out a business loan to replace several of the lifts in his garage. He estimates that he’ll need to take out $15,000 to buy the equipment. The garage currently brings in $130,000 a year in sales. His annual expenses/payments are as follows:
- Rent: $20,000
- Labor: $25,000
- Utilities: $5,000
- Business Credit Card Debt: $5,000
Now, let’s calculate the numerator (top part) of the equation for the GDS:
Rent + Labor + Utilities = $20,000 + $25000 + $5,000 = $50,000
His GDS will then be:
$50,000 / $150,000 * 100 = 30%
NowNow, let’s calculate the numerator (top part) of the equation for the GDS:
Rent + Labor + Utilities + Credit Card = $20,000 + $25000 + $5,000 + $5,000 = $55,000
His TDS will then be:
$55,000 / $150,000 * 100 = 36.7%
These ratios indicate that Carlos shouldn’t have any problems getting a loan for his business. However, if Carlos takes out this loan, he will only be able to take on annual payments of $5,000 before his TDS exceeds 40%. The interest rate and length of the loan will determine the size of Carlos’s annual payments.
You need to understand your debt service coverage ratio before applying for a loan. This gives you a starting point to see how different loan amounts, rates, and terms will impact your ratios. From there you can make better decisions on the best loan options that save you money and minimize your burden.