The debt-to-income ratio, also known as the back-end ratio, is a figure that shows how much of a person's monthly income goes toward paying off debts. Mortgage payments (principal, interest, taxes, and insurance), credit card payments, child support, and other loan payments all contribute to total monthly debt.
(Total monthly debt expenditure / Gross monthly income) x 100 = Back-End Ratio
This ratio, along with the front-end ratio, is used by lenders to approve mortgages.
DECONSTRUCTION Back-End to Front-End Ratio
The back-end ratio is one of a few measures used by mortgage underwriters to determine the amount of risk involved in lending money to a potential borrower. It's significant because it indicates how much of the borrower's revenue is owing to someone or a corporation other than the borrower. If a large portion of an applicant's monthly wage goes toward debt payments, the applicant is classified as a high-risk borrower, since a job loss or income cut might result in unpaid obligations piling up quickly.
Back-End Ratio Calculation
The back-end ratio is derived by multiplying a borrower's monthly loan payments by his or her monthly income.
Consider a borrower with a $5,000 monthly income ($60,000 divided by 12) and $2,000 in total monthly debt payments. The back-end ratio for this borrower is 40% ($2,000 / $5,000).
Lenders prefer a back-end ratio of less than 36 percent in most cases. Some lenders, however, grant exceptions for customers with strong credit who have ratios of up to 50%. When underwriting mortgages, some lenders utilize this ratio alone, while others use it in conjunction with the front-end ratio.
Ratio of Back-End to Front-End
The front-end ratio, like the back-end ratio, is a debt-to-income comparison used by mortgage underwriters, with the exception that the front-end ratio does not take into account any debt other than the mortgage payment. As a result, the front-end ratio is computed by dividing the borrower's monthly mortgage payment by their monthly income. Assume that the borrower's monthly debt obligation is $2,000, and that their mortgage payment is $1,200 of that total.
The front-end ratio for the borrower is ($1,200 / $5,000), or 24 percent. A frequent top restriction set by mortgage providers is a front-end ratio of 28 percent. Certain lenders, including back-end lenders, are more flexible with front-end ratios, especially if a borrower has other mitigating characteristics like strong credit, consistent income, or big cash reserves.
How to Boost Your Back-End Ratio
A borrower can reduce their back-end ratio by paying off credit cards and selling a financed automobile. Consolidating other debt with a cash-out refinance can decrease the back-end ratio if the mortgage loan being sought for is a refinance and the home has enough equity. However, because cash-out refinances carry a higher risk for lenders, the interest rate is frequently somewhat higher than a conventional rate-term refinancing to compensate for the increased risk. Furthermore, many lenders demand a borrower who is paying down revolving debt in a cash-out refinancing to shut the debt accounts that are being paid off, lest his balance be raised again.
