The back-end ratio, also known as the debt-to-income ratio, is a measure that highlights what portion of a person’s monthly income is dedicated to paying off debts. This total monthly debt includes expenses like mortgage payments (principal, interest, taxes, and insurance), credit card payments, child support, and other loan repayments.
Back-End Ratio = (Total monthly debt expense / Gross monthly income) x 100
Lenders utilize this ratio along with the front-end ratio to approve mortgages. A lower back-end ratio generally indicates a lower risk for lenders.
Key Takeaways
- Back-end ratios indicate the percentage of income a borrower allocates to debt payments.
- To calculate a back-end ratio, divide total monthly debt expenses by gross monthly income and multiply by 100.
- Mortgage underwriters use back-end ratios to assess borrower risk.
- Lenders often require long-term debt and housing expenses to constitute less than 33% to 36% of a borrower’s gross income.
How Back-End Ratio Works
The back-end ratio is one of several metrics mortgage underwriters employ to determine the risk level associated with lending to a prospective borrower. It signifies how much of a borrower’s income is committed to paying someone else or another entity.
A back-end ratio is also known as a total fixed payments to effective income ratio. Lenders commonly require long-term debt and housing expenses to be under 33% to 36% of a borrower’s gross income.
Applicants whose significant portion of monthly income goes toward debt payments are considered high-risk borrowers. For such individuals, a job loss or income reduction can easily result in financial strain and missed payments.
Calculating Your Back-End Ratio
You can calculate the back-end ratio by adding all monthly debt payments and dividing the sum by the monthly income, then multiplying by 100.
Consider a borrower who earns $5,000 monthly ($60,000 annually divided by 12) and has total monthly debt payments of $2,000. This borrower’s back-end ratio would be 40% ($2,000 / $5,000
- 100).
Generally, lenders prefer a back-end ratio not exceeding 36%. However, good credit might allow exceptions for ratios of up to 50%. Some lenders use this ratio solely for mortgage approval, while others combine it with the front-end ratio.
Back-End vs. Front-End Ratio
Like the back-end ratio, the front-end ratio is another debt-to-income comparison used by mortgage underwriters. The difference lies in the scope; the front-end ratio considers only the mortgage payment.
To calculate the front-end ratio, divide just the mortgage payment by the borrower’s monthly income. For example, if a borrower’s total monthly debt is $2,000, and the mortgage payment is $1,200, with a monthly income of $5,000, the front-end ratio is $1,200 / $5,000 = 24%.
A common upper limit for the front-end ratio imposed by mortgage companies is 28%. Flexible lenders might offer more lenience, especially if excellent credit, reliable income, or substantial cash reserves are present.
Tips to Improve Your Back-End Ratio
Lowering your back-end ratio can enhance your financial health and loan approval chances. Here are some strategies:
- Pay off credit cards
- Sell financed assets (e.g., cars)
- Consolidate other debts through cash-out refinancing if enough home equity exists
However, a cash-out refinance often carries a slightly higher interest rate due to higher lender risk. Moreover, many lenders will require the closure of debt accounts settled through this strategy to avoid accumulating a new balance.
Back-End Ratio Guidelines
Typically, lenders like a back-end ratio of no more than 36%. However, exceptions might be made, with some lenders allowing a maximum of 43%.
Front-End Ratio Basics
The front-end ratio represents the percentage of your housing expenses concerning your total monthly income. To calculate it, divide your total housing expenses—such as mortgage payment, property taxes, mortgage insurance, and homeowner’s association fees—by your total income.
Desired Front-End Ratio
A common requirement among lenders is a front-end ratio of at least 28% for mortgage approval. Lower front-end and back-end ratios generally increase your chances of obtaining a mortgage.
The Bottom Line
Understanding your back-end ratio is crucial when preparing to take out a mortgage or other loans. Lenders use this ratio to gauge how risky lending to you might be. To make your financial profile more attractive, working to minimize debt and increase your income is key. Consulting a financial advisor can help you understand how your back-end ratio fits into your broader financial picture.
Related Terms: Front-End Ratio, Debt-to-Income Ratio, Mortgage Underwriting, Credit Score, Cash-Out Refinance
References
- U.S. Department of Housing and Urban Development. “Borrower Qualifying Ratios”.
- FDIC. “Loans and Mortgages”.
