What is the 'Back-End Ratio'
The back-end ratio, also known as the debt-to-income ratio, is a ratio that indicates what portion of a person's monthly income goes toward paying debts. Total monthly debt includes expenses such as mortgage payments (principal, interest, taxes and insurance), credit card payments, child support and other loan payments. Lenders use this ratio in conjunction with the front-end ratio to approve mortgages.
BREAKING DOWN 'Back-End Ratio'The back-end ratio represents one of a handful of metrics that mortgage underwriters use to assess the level of risk associated with lending money to a prospective borrower. It is important because it denotes how much of the borrower's income has someone else's name on it. If a high percentage of an applicant's paycheck goes to debt payments every month, the applicant is considered a high-risk borrower, as a job loss or income reduction could cause unpaid bills to pile up in a hurry.
Calculating the Back-End Ratio
The back-end ratio is calculated by adding together all of a borrower's monthly debt payments and dividing the sum by the borrower's monthly income.
Consider a borrower whose monthly income is $5,000 ($60,000 annually divided by 12) and who has total monthly debt payments of $2,000. This borrower's back-end ratio, then, is ($2,000 / $5,000), 40%.
Generally, lenders like to see a back-end ratio that does not exceed 36%; however, there are lenders who make exceptions for ratios of up to 50% for borrowers with good credit. Some lenders consider only this ratio when approving mortgages, while others use it in conjunction 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 only difference being the front-end ratio considers no other debt than the mortgage payment. Therefore, the front-end ratio is calculated by dividing only the borrower's mortgage payment by his monthly income. Returning to the example above, assume that out of the borrower's $2,000 monthly debt obligation, his mortgage payment comprises $1,200 of that amount.
The borrower's front-end ratio, then, is ($1,200 / $5,000), or 24%. A front-end ratio of 28% is a common upper limit imposed by mortgage companies. Like with the back-end ratio, certain lenders offer greater flexibility on front-end ratio, especially if a borrower has other mitigating factors, such as good credit, reliable income and large cash reserves.
How to Improve a Back-End Ratio
Paying off credit cards and selling a financed car are two ways a borrower can lower his back-end ratio. If the mortgage loan being applied for is a refinance and the home has enough equity, consolidating other debt with a cash-out refinance can lower the back-end ratio. However, because lenders incur greater risk on a cash-out refinance, the interest rate is often slightly higher versus a standard rate-term refinance to compensate for the higher risk. In addition, many lenders require a borrower paying off revolving debt in a cash-out refinance to close the debt accounts being paid off, lest he runs his balance back up.