BACK END RATIO: What It Is and How To Calculate It

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The back-end ratio is one of the metrics banks and even the FHA consider when making lending decisions. Also known as the DTI ratio, it determines the level of risk associated with lending money to a prospective borrower. Here’s all you need to know about the back end ratio and how to calculate it.

What Is A Back End Ratio?

The “back-end ratio” is the percentage of your monthly income dedicated to debt payments. The ratio is determined as a percentage of your monthly income.

Understanding The Back-End Ratio

The back-end ratio is one of a few metrics used by mortgage underwriters to determine the level of risk associated with lending money to a prospective borrower. It is significant because it indicates how much of the borrower’s income is owed to another person or company. If a large portion of an applicant’s monthly income goes toward debt payments, the applicant is deemed a high-risk borrower, as a job loss or income drop could cause unpaid liabilities to pile up quickly.

How To Calculate The Back-End Ratio 

To calculate the back-end ratio, we combine all of a borrower’s monthly debt payments together and divide the total by the borrower’s monthly income.

Consider a borrower with a $5,000 monthly income ($60,000 divided by 12) and total monthly debt payments of $2,000. The back-end ratio for this borrower is 40% ($2,000 / $5,000).

Lenders prefer to see a ratio of no more than 36 percent. Some lenders, however, grant exceptions for percentages of up to 50% for borrowers with good credit. When accepting mortgages, some lenders utilize this ratio solely, while others use it in conjunction with the front-end ratio.

How to Determine the Back End Ratio

Your monthly debt in a back-end ratio comprises credit card, mortgage, and vehicle loan payments, as well as child support and other loan commitments. Because of the debts included, it differs from a front-end ratio. The “front-end” ratio is just the mortgage payment to income ratio.

So, if you make $48,000 a year, your monthly income is $4,000. Your front-end ratio is 25% if your total mortgage payment is $1,000.

If your total debt payments are $1,800 ($1,000 for home, $350 for auto loan, $300 for credit cards, and $150 for student loan), your back-end ratio is 45 percent.

Your overall debt-to-income ratio (DTI) would be 25/45 (front/back).

Read Also: FILING BACK TAXES: How Do I Manage My Back Taxes?

How Is This Calculation Used by Lenders?

When providing mortgage loans, some lenders assess solely the back-end ratio and give no weight to the front-end ratio. Debt-to-income ratios, together with the borrower’s credit score, income, job history, the property being acquired, and other factors, play a significant role in the lender’s decision.

The back-end to front-end ratio is more conservative. That is, lenders with stricter lending rules are more inclined to look at the back end of the transaction rather than the front end.

Lenders have criteria with which they enter into loan negotiations. Lenders generally aim to make loans with a ratio of 36% or less. So, in the preceding scenario, with a back-end ratio of 45 percent, the loan would most likely be denied. If the borrower has good credit, some lenders will make an exemption, allowing ratios of up to 50%.

Lenders who calculate both the front and rear end ratios may request a certain ratio, such as 28/36. The FHA loan limit is 29/41. VA loans only consider the back end, which must be 41 percent or lower.

How To Lower Your Back End Ratio

Because your debt-to-income ratio is as significant to mortgage lenders as your credit score, boosting your ratio is critical to ensuring that you can acquire the loans you need and that you’ll be able to afford your loan payments after the loan is granted.

The most effective strategy to minimize your back-end ratio is to pay down debt. If you can pay off your credit cards and avoid accruing new revolving debt, your ratio will improve significantly. If you paid off your credit cards in the above situation, you’d be left with $1500 in monthly payments ($1000 home, $350 auto loan, $150 student loans). With $4000 in earnings, the new back-end ratio is 37.5 percent. That is far closer to the acceptable 36 percent, and with a strong credit score, most lenders may even approve you.

Increasing income improves the ratio as well. Assume you receive a 3% cost-of-living increase in our example. Your new monthly income of $4,120, combined with your monthly debt payments of $1,500, results in a back-end ratio of 36.4 percent. This ratio increases the likelihood of your loan application being granted.

Reduce your mortgage payment to boost your ratio. You can lower your payment and lower your front and back end ratios by making a higher down payment, choosing a 20 or 30-year mortgage instead of a 15-year mortgage, or looking for a more cheap house to buy. Obtaining more affordable insurance also benefits here, because your mortgage payment includes PITI (principal, interest, taxes, and insurance).

Back End Ratio vs Front End Ratio

The front-end ratio is also a debt-to-income comparison used by mortgage underwriters. The exception is that the front-end ratio considers no debt other than the mortgage payment. As a result, we calculate the front end ratio by dividing the borrower’s monthly mortgage payment by his or her monthly income. Returning to the previous example, assume that the borrower’s mortgage payment is $1,200 of their $2,000 monthly debt obligation.

Therefore, the borrower’s ratio is ($1,200 / $5,000), or 24 percent. A frequent upper restriction set by mortgage providers is a front-end ratio of 28 percent. As with the back-end ratio, some lenders are more flexible on the front-end ratio, especially if the borrower has other mitigating circumstances such as good credit, consistent income, or big cash reserves.

Compensating Factors For FHA Back End DTI Ratio

If borrowers meet different compensating circumstances, FHA requirements allow lenders to allow for greater DTI percentages. These extra scenarios help to mitigate the risk of issuing mortgages with greater DTI ratios. Among these compensating factors are the following:

#1. Residual Income

Lenders may approve higher debt-to-income ratios if the borrower has sufficient funds remaining each month after all costs are covered.

#2. Cash Reserves

Another offsetting factor would be if the borrower has considerable cash reserves on hand after closure in the event of a financial emergency.

#3. Payment Shock

Payment shock occurs when a borrower’s monthly housing payment increases dramatically while purchasing a home and transferring from the previous rent/mortgage payment to the new suggested payment. If the borrower’s payments remain almost consistent under the new mortgage payment scenario, lenders will be more willing to approve the higher DTI.

#4. High Credit Scores

If you have a high credit score, you have demonstrated financial responsibility. This will help you be accepted for a greater DTI.

#5. Employment Stability

Have you been working at the same location for a long time, or have you been jumping from job to job with numerous breaks in employment throughout the last few years? It will be critical to have a consistent source of income.

FHA lenders may tolerate a back end DTI ratio of more than 50% with these and other compensatory considerations.

How To Lower Your DTI

The most obvious way to lower your DTI is to either increase your monthly income or reduce your monthly debt. There are, however, some less obvious suggestions that we shall discuss with you here.

#1. Increase Your Income

If you are self-employed or earn cash or tips in your field of work, you must be able to demonstrate this income when applying for a mortgage. Others make the error of failing to deposit all revenue, including cash and tips, into a bank account.

Lenders will want to examine how much money is coming into your bank accounts. It makes no difference if you withdraw the monies immediately after. Documenting your cash flow is one strategy to enhance your recorded gross monthly income, which will lower your DTI ratios.

#2. Reduce Your Monthly Debt

Large monthly payment requirements frequently push up DTI percentages. If you’re intending to pay down debt to improve your DTI ratios before qualifying for a mortgage, focus on the obligation with the highest monthly payment demand, not the debt with the highest total.

The goal is to have all monthly payments removed from your credit portfolio. As a result, if you have $5,000 available to pay off debt, you should utilize it to pay off as many accounts as feasible. Those payments would be removed from your DTI calculation. What you don’t want to do is apply the $5,000 to an account with a significantly bigger amount while keeping the monthly payment.

What Is The Highest FHA Back End DTI Ratio Permissible?

The highest permissible FHA back end DTI Ratio with compensating factors is 56.9 percent, which participating FHA lenders may allow based on specific compensating elements that serve to reduce the lender’s risk.

What Income Can Be Used To Estimate Back End DTI Ratio?

Debt to income ratios can be calculated using the following forms of income:

  • Wages for a month’s work
  • Profits from your business
  • Social Security benefits
  • 401k earnings
  • Pensions
  • Income from Disability
  • Child support and alimony

Can I Get an FHA Loan With a High Back End DTI Ratio?

There are lenders who will accept DTI levels of up to and beyond 50%. Working closely with the correct lender will assist guide you through the process and propose ways to qualify.

FHA Debt-To-Income Ratio and Student Loans

FHA lenders are obligated to include 1% of the student loan outstanding in the monthly requirements when calculating debt to income.

What Is an Appropriate Debt-to-Income Ratio?

As a general rule, the highest DTI ratio a borrower can have while still qualifying for a mortgage is 43 percent. Lenders prefer a debt-to-income ratio of less than 36 percent, with no more than 28 percent of the debt dedicated to mortgage or rent payments.

The maximum DTI ratio varies depending on the lender. However, the lower the debt-to-income ratio, the more likely the borrower will be accepted, or at least considered, for credit.

What Are the Debt-to-Income Ratio’s Limitations?

The DTI ratio does not differentiate between various types of debt or the expense of servicing that debt. Credit cards have higher interest rates than student loans, yet they are combined in the DTI calculation.

Your monthly payments would be reduced if you switched balances from high-interest credit cards to low-interest credit cards. Your total monthly debt payments and DTI ratio would decrease as a result, but your overall debt outstanding would remain the same.

In Conclusion,

Your back end ratio is essentially your entire debt to income ratio. This includes your planned housing debt as well as any other consumer debt on your credit record. Knowing to calculate the back end ratio will eventually determine whether your income levels are sufficient to qualify for the mortgage you are asking for. This will in turn help you to know what to work on.

Frequently Asked Questions

What is the back end ratio of DTI?

Your back-end ratio is the ratio of your overall monthly debt obligations, including your mortgage and any associated housing debt, to your gross income.

What is the minimum back end ratio for a conventional loan?

The minimum back end ratio for a conventional loan is 45% to %50%

What is the 28% rule?

When considering a mortgage, ensure that your maximum monthly household expenses do not exceed 28 percent of your gross monthly income and that your overall household debt does not exceed 36 percent of your gross monthly income.

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