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What is the Back-End Ratio?
Why Back-End Ratio?
The back-end ratio is significant because it shows the percentage of the borrower's income that is owing to third parties or to a different business. A borrower who has a high back-end ratio is deemed to be at high risk since it suggests that a significant portion of their monthly income is being used to pay off debt. Individuals who produce a low ratio, however, will be regarded as low-risk borrowers.The formula for Back-End Ratio
The back-end ratio can be calculated by summing the borrower’s total monthly debt expenses and dividing it by their monthly gross income. The formula is shown below:Back-End Ratio = (Total monthly debt expense / Gross monthly income) x 100
Total monthly debt expenses include but are not exclusive to:
- Credit card bills
- Mortgages
- Insurance
- Other loans
How to Calculate Back-End Ratio
To calculate the back-end ratio, follow these steps:- Add up all monthly debt payments.
- Divide the total monthly debt payments by the monthly gross income.
- Multiply the value by 100 to get the percentage amount.
For example, Johnny earns $6,000 per month and owes $1,000 in credit card bills, a $600 mortgage payment, and $500 in other various loans. In aggregate, his total monthly debt payments are $2,100. Johnny’s back-end ratio is 35% [ ($2,100 / $6,000) * 100].
Examples of Back-End Ratio
Let's look at some more examples of back-end ratio calculations.- Betty earns $5,000 and owes $1,500 per month. Her back-end ratio is 30% [ ($1,500 / $5,000) * 100].
- Sam earns $4,000 and owes $800 per month. His back-end ratio is 20% [ ($800 / $4,000) * 100].
- Lisa earns $3,000 and owes $1,200 per month. Her back-end ratio is 40% [ ($1,200 / $3,000) * 100].
Limitations of Back-End Ratio
The back-end ratio has some limitations as a measure of borrower's risk. Some of them are:- Other expenses like groceries, utilities, and transportation that are not classified as debt are not included in the back-end ratio. The borrower's capacity to repay their debts may also be impacted by these costs.
- The terms and interest rates of the loans are not considered by the back-end ratio. The cash flow and debt load of the borrower may be affected differently over time by different loans.
- The borrower's credit score and credit history are not reflected in the back-end ratio. The choice of the lender to accept or deny a loan application may also be influenced by these variables.
FAQ
The back-end ratio is a measure that signifies the portion of monthly income used to settle debts. It is used by lenders to assess a borrower's capacity and risk to pay off monthly debt.
The back-end ratio can be calculated by dividing the borrower’s monthly debt expenses by their monthly gross income.
The formula is: Back-End Ratio = (Total monthly debt expense / Gross monthly income) x 100
Monthly debt expenses include but are not exclusive to credit card bills, mortgages, insurance, and other loans.
Lenders often prefer to see a back-end ratio of no more than 36%. For borrowers with good credit, certain lenders do, nevertheless, make exceptions for ratios of up to 50%.
Reducing your monthly loan payments or raising your gross monthly income are the two strategies to lower your back-end ratio. You may, for instance, refinance your loans with longer terms or cheaper interest rates, pay off part of your bills, or look for other sources of income.
The main distinction between the front-end and back-end ratios is that the former solely takes into account mortgage interest as a kind of debt expense. The housing expense ratio is another name for the front-end ratio.
