To start, a back-end ratio is also known by many as a debt-to-income ratio. This ratio shows how much of an individual’s monthly income is spent paying debts. Further, monthly debt payments can include a multitude of expenses such as mortgage payments, credit card payments, car payments, child support, or other outstanding loan payments. In equation form, the back-end ratio looks like this:
Back-end ratio = total monthly debt / monthly income x 100
Why is this useful? Great question. The back-end ratio is most commonly used as a metric that mortgage underwriters refer to when assessing the level of risk associated with lending capital to a specific potential borrower. In fact, a back-end ratio is often used along with a few different metrics, however, for the team-being it is important for you to understand the basics. That said, this ratio is of special interest to lenders because it outlines what portion of a prospective borrower’s income is already spent elsewhere. This means that the lender can see how much money the borrower would truly have to pay back a loan. As such, the greater the portion of an individual’s check that goes towards debt payments each month, the higher the risk they are as a borrower. Generally, more debt equates to a higher rate of payment default.
To provide a real-world example, imagine that a potential borrower has a monthly income of $6,500 — which means they make $78,000 annually — and has monthly debt expenses of $1,500. In this scenario, the prospective borrower has a back-end ratio of roughly 23% ($1,500 / $6,500). Typically, lenders try to avoid borrowers whose back-end ratio is greater than 36%. Yet, in some instances, lenders are willing to make special considerations for individuals with relatively high back-end ratios that have strong credit scores. Keep in mind, only some lenders solely take back-end ratio into consideration while making decisions, whereas many others utilize multiple other metrics. Moreover, one such metric is known as the front-end ratio.
While the front-end ratio is similar to the back-end ratio because it is used by mortgage underwriters as a debt-to-income comparison metric, it is different as it considers no debt other than mortgage payments. As result, the front-end ratio is simply calculated by dividing the prospective borrower’s mortgage payment by their monthly income. If we continue to consider our previous scenario and estimate that $1,000 of our borrowers $1,500 monthly debt comes from their mortgage, then their front-end ratio is around 15%. For reference, it is common for mortgage companies to require a front-end ratio of 30% or lower, although, there are always some special cases. Some of these special cases include individuals that have particularly great credit scores, very reliable income, or significant cash reserves that can be easily accessed.
At some point in your life you will likely need to take out a large loan, such as a mortgage. As you have now learned, one of the most important factors to consider before doing so is the quality of your back-end ratio. Fortunately, if you seem to be struggling with achieving a desirable ratio for lenders, there are some steps that can be taken. For example, paying off outstanding credit card debt or car payments can significantly impact your ratio in a positive way. On the other hand, discovering ways to earn extra monthly income — without accumulating debt — would also result in a better back-end ratio. Ultimately, and as previously mentioned, it is likely that you will someday want to take out a large loan (probably mortgage) and while doing so will want to make sure that you have best set yourself up for success. While understanding back-end ratios is not the sole piece of information you will need to know, it is certainly a great starting point. Perhaps you could benefit even further by diving into your own independent study before taking out such a loan. As always, due diligence is key!