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.
Limitations of the Back-End Ratio
It is important to recognize that the back-end ratio is simply one of many metrics that can be used to understand the borrower’s ability to settle their debt. Lenders can analyze the borrower’s credit history and credit score to make a decision on whether extending or raising credit is worthwhile.
The back-end ratio does not recognize the different types of debt and service costs of debt. For example, although credit cards yield a higher interest rate than student loans, they are added together in the numerator within the ratio.
If the borrower transfers balances from a low-interest credit card to a higher one, evidently, the monthly debt payments will be higher. Thus, the back-end ratio should be higher as well. However, as the ratio sums all debt in one package, the total debt outstanding remains the same.
What is the Front-End Ratio?
The front-end ratio is similar to the back-end ratio; however, the primary difference is that the front-end ratio only considers mortgage as the debt expense. Thus, the numerator will only be mortgage payments, while the denominator is the monthly income.
To calculate the front-end ratio, divide the mortgage payment by the monthly income. For example, if the borrower owes $1,500 in debt and $1,000 of it comes from a mortgage, while earning a monthly salary of $6,000, then their front-end ratio is $1,000 / $6,000 = 16.67%.
Unlike the back-end ratio, the front-end ratio comes with an upper limit of 28% for mortgages. The higher the ratio, the increase in the likelihood that the borrower will default on the mortgage, and vice-versa if the ratio is lower.
How does the back-end ratio differ from the 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 the front-end ratio, especially if a borrower has other mitigating factors, such as good credit, reliable income, or large cash reserves.
How do you calculate your back-end ratio?
Calculating your back-end ratio is pretty straightforward. Add all your monthly recurring debts with 10 or more months of payments remaining on them and divide them by your monthly gross income.
Consider you have the following debt payments:
- $500 in credit card payments
- $300 car loan payment
- $1,500 mortgage payment (including property taxes and insurance)
- $600 child support payment
You would have $2,900 in monthly debt payments. Now, assume you earn $120,000 per year, which would be $10,000 in gross monthly income. Divide $2,900 by $10,000, and you get 0.29, which is a 29% back-end ratio.
Lenders can use various sources of income to calculate your back-end ratio. Some of the income sources include:
- Normal salary
- Yearly bonus
- Self-employment income
- Social Security income
- 401(k) disbursements
- Pension payments
- Disability payments
- Alimony or child support received
How does your back-end ratio impact loan approval?
Your back-end ratio can be a make-or-break factor in getting approved for a loan or mortgage. Your credit history is typically the first thing lenders look at, but if they determine you can’t afford the loan because your DTI ratio is too high, they’ll likely deny you.
Each lender has differing back-end DTI ratio requirements, and their strictness will often change with your credit score, previous mortgage payment history, surplus monthly income, and more.
For lenders who work with government-backed lending programs, like the Federal Housing Administration (FHA), there are guidelines they must work within. Each lender can still maintain its guidelines as long as they fit within the FHA loan’s minimum requirements.
For example, someone seeking an FHA loan must have a back-end ratio of 43% or less. An individual lender can tighten its FHA restrictions to 40% or lower. However, the lender can’t loosen its back-end ratio requirement to 45% without the buyer meeting specific FHA-permitted exceptions, like buying an energy-efficient home or showing additional cash reserves (savings).
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 to pay off the revolving debt in a cash-out refinance to close the debt accounts being paid off, lest they run his balance back up.