Back-End Ratio ; How Does Back-End Ratio Work?

What is the Back-End Ratio?

The back-end ratio in loan terms is the portion of a person’s gross income that is given to debt service. You can check it by dividing all monthly debt payments by one’s gross monthly income. The back-end ratio is used to check whether or not to extend credit to people. Some lenders also use it with the front-end ratio, while others go for the back-end ratio only. Understand that, the lower your back-end ratio is, the more likely you can get a loan. On the whole, lenders do not make loans to a person with this ratio of more than 0.36, but there are cut backs for those with good credit.

How Does It Ratio Work?

It is checking a borrower’s ability in meeting the underwriting baseline for a loan. It is a method that takes into account the long-term debt of the person, as well as the payments on the loan, in order to arrive at an amount that will be given to debt service. Most times, lenders like to see ratios below 36 percent of take-home pay. This is in contrast with the front-end ratio, which only compares the loan against take-home pay.

Does Back-End Ratio Really Matter?

This is a way to see a borrower’s credit risk. As earlier stated, many lenders use the ratio instead of or in line with the front-end ratio, which also evaluates a borrower’s financial role in relation to his or her income. Most lenders have a rule of thumb that a borrower’s ratio is not to exceed 36%, even though a borrower with good credit is chosen in special cases.

How to Lower Back-End Ratio

A person ratio can be lowered in two ways:

  • By reducing the monthly debt payments
  • Increasing the gross monthly income.

Front-End Ratio

The front-end ratio is quite similar to the back-end ratio. The only difference being that the front-end ratio only considers mortgage as the debt expense. What this implies is that the numerator will only be mortgage payments, while the denominator is the monthly income.

In calculating the front-end ratio, divide the mortgage payment by the monthly income.

The front-end ratio unlike the back-end ratio comes with an upper limit of 28% mortgages. Thus, the higher the ratio, the rise in the chance that the borrower will default on the mortgage, and vice-versa where the ratio is lower.

Limitations of Back-End Ratio

This ratio does not take into account the many types of debt and service costs.

In a case where a borrower transfers balances from a low-interest credit card to a higher one, typically, the monthly debt payments will be higher. So, the ratio should be higher also. Howbeit, as the ratio sums all debt in one package, the total debt outstanding stays the same.

Thus at the end of the day, lenders are to understand that the back-end ratio is only one of many metrics that can be used to understand the borrower’s ability in repaying their debt. So lenders are to analyze the borrower’s credit history and credit score to make a decision on whether or not to extend credit.

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