Back-End Ratio: Definition, Calculation Formula, Vs. Front End

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.

Back-End Ratio = (Total monthly debt expense / Gross monthly income) x 100

Lenders use this ratio in conjunction with the front-end ratio to approve mortgages. The lower your back-end ratio, the lower risk you are.

How Back-End Ratio Works

The back-end ratio represents one of several 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 is owed to someone else or another company.

A back-end ratio is also called a total fixed payments to effective income ratio.

If a high percentage of an applicant's paycheck goes to debt payments every month, the applicant is considered a high-risk borrower. For these borrowers, a job loss or income reduction could more easily result in financial strain and missed payments.

How to Calculate a 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 and multiplying by 100.

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 is 40% ($2,000 / $5,000 * 100). 

Generally, lenders like to see a back-end ratio that does not exceed 36%. However, some lenders make exceptions for ratios of up to 50% for borrowers with good credit. Some lenders consider only use 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 debt other than the mortgage payment. Therefore, the front-end ratio is calculated by dividing only the borrower's mortgage payment by his or her monthly income. Returning to the example above, assume that out of the borrower's $2,000 monthly debt obligation, their 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, or 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 their 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 the revolving debt in a cash-out refinance to close the debt accounts being paid off, lest they run the balance back up.

The Bottom Line

Understanding your back-end ratio is key to preparing for getting a mortgage and other types of loans, as lender use this ratio among other factors to assess how risky you are. You can improve your back-end ratio by minimizing debt and increasing income. Consider consulting a professional financial advisor to review how your back-end ratio fits into your financial picture.