What is the ‘Back-End Ratio’
An indicator of how much of a person’s monthly income is dedicated to debt repayment is the back-end ratio, also known as the debt-to-income ratio. A person’s total monthly debt comprises expenditures such as mortgage payments (principal plus interest, taxes, and insurance), credit card payments, child support, and other loan payments, among other things. Lenders utilize this ratio in conjunction with the front-end ratio to determine whether or not to accept mortgage applications.
Explaining ‘Back-End Ratio’
The back-end ratio is one of a number of measures that mortgage underwriters use to determine the level of risk involved with lending money to a potential borrower, and it is calculated as a percentage of the loan amount. It is significant since it indicates how much of the borrower’s income is derived from sources other than his or her own.
If a significant portion of an application’s monthly income is dedicated to debt repayment, the applicant is deemed a high-risk borrower since a job loss or income reduction might result in an accumulation of unpaid obligations in a short period of time.
Calculating the Back-End Ratio
It is possible to determine the back-end ratio by adding up all of a borrower’s monthly loan payments and then dividing the total by the borrower’s monthly income.
Back-End vs. Front-End Ratio
The front-end ratio is a debt-to-income comparison used by mortgage underwriters that is similar to the back-end ratio, with the sole distinction being that the front-end ratio does not take into account any other debt other than the mortgage payment.
Consequently, the front-end ratio is determined by dividing solely the borrower’s mortgage payment by the borrower’s gross monthly earnings (or gross monthly income). Returning to the previous example, imagine that the borrower’s monthly debt obligation is $2,000, and that his mortgage payment represents $1,200 of that total.
How to Improve a Back-End Ratio
A borrower can reduce his back-end ratio by paying off credit cards and selling a financed vehicle, to name a few options. The back-end ratio can be reduced by merging other debts with a cash-out refinance if the mortgage loan being sought for is a refinance and there is sufficient equity in the house.
However, because lenders are taking on more risk with a cash-out refinance, the interest rate on a cash-out refinance is often somewhat higher than the interest rate on a normal rate-term refinance in order to compensate for the extra risk.
To add insult to injury, many lenders demand a borrower paying down revolving debt in a cash-out refinancing to shutter the debt accounts that are being paid off, lest he re-inflate his account amount.
Back End Ratio FAQ
What is a good back end DTI ratio?
Lenders normally want a front-end ratio of no more than 28 percent, and a back-end ratio of no more than 36 percent, which includes all monthly bills and other obligations.
What is not included in back end ratio?
The back-end ratio does not take into account the various forms of debt or the costs associated with debt payment. For example, despite the fact that credit cards have a greater interest rate than student loans, the two are included in the numerator of a ratio.
What is the 36 rule?
The 28/36 rule is a useful tool for determining how much of your income should be allocated to your mortgage payments. Following this approach, you should not have a monthly mortgage payment that is greater than 28 percent of your monthly pre-tax income or greater than 36 percent of your total debt. Alternatively, the debt-to-income (DTI) ratio is used to measure this.
What's DTI ratio?
This ratio measures how much you owe each month in relation to how much money you make each month in your bank account. In particular, it refers to the percentage of your total monthly income (before taxes) that is allocated to debt payments such as rent, mortgage, credit card bills, and other obligations.
Are utilities included in back end ratio?
In other words, the back end ratio analyzes how much of your income is required to pay down all of your monthly bills. In addition to loans, credit cards, and other monthly credit responsibilities, these debts include housing expenditures and other monthly credit commitments. Utilities and other similar expenses are not included.
Further Reading
- A Degree of Practical Wisdom: The Ratio of Educational Debt to Income as a Basic Measurement of Law School Graduates’ Economic Viability – heinonline.org [PDF]
- A Degree of Practical Wisdom: The Ratio of Educational Debt to Income as a Basic Measurement of Law School Graduates’ Economic Viability – papers.ssrn.com [PDF]
- Economic impact of distribution fees on mutual funds – search.proquest.com [PDF]
- Systematic mistakes in the mortgage market and lack of financial sophistication – www.sciencedirect.com [PDF]
- Are mutual fund investors in jail? – www.tandfonline.com [PDF]
- The regulatory environment and housing finance market in Ghana – www.emerald.com [PDF]
- Financial literacy and student debt – www.tandfonline.com [PDF]
- Mortgage Pricing and Gender: A Study of New Century Financial Corporation – search.proquest.com [PDF]
- Optimal Choice of Preferential Tax Pension Insurance Mode—Based on the Analysis of Payroll Tax Ratio Effect – en.cnki.com.cn [PDF]
