What is the Back-End Ratio?
The back-end ratio is a measure that signifies the portion of monthly income used to settle debts. Lenders, such as bondholders or issuers of mortgages, use the ratio to determine the borrower’s ability to manage and pay off monthly expenses. Therefore, the back-end ratio assesses the borrower’s risk.
If the borrower’s back-end ratio yields a high value, it indicates that a large sum of their monthly income is allocated to debt payments on a monthly basis; thus, they will be perceived as a high-risk borrower. Whereas, for individuals that yield a low ratio, they will be considered a low-risk borrower. Typically, a borrower’s back-end ratio should not exceed 36%; however, there are indeed exceptions where ratios are up to 50% for those with exceptional credit.
How to Calculate the 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:
- 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.
Total monthly debt expenses include but are not exclusive to:
- Credit card bills
- Other loans
In a month, Johnny 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. He earns $6,000 per month. Johnny’s back-end ratio is 35% [($2,100 / $6,000) * 100].
How to Lower the Back-End Ratio
There are two ways to lower an individual’s back-end ratio:
- Reduce the monthly debt payments
- Increase the gross monthly income
For example, Betty earns $5,000 and owes $1,500 per month. It is equivalent to a 30% back-end ratio. However, if she owes $1,200 per month while continuing to earn $5,000, she would yield a 24% back-end ratio. From a different aspect, if Betty earns $6,000 and owes $1,500 per month, she will show a ratio of 25%.
As the denominator stays constant while the numerator decreases, the overall ratio will decrease. The same result will occur if the denominator increases while the numerator stays constant. If the numerator decreases while the denominator increases, the back-end ratio will fall significantly relative to the previous two scenarios.
The front-end ratio is similar to the back-end ratio; however, the primary difference is that the front-end ratio only considers mortgage as the debt expense. Thus, the numerator will only be mortgage payments, while the denominator is the monthly income.
To calculate the front-end ratio, divide the mortgage payment by the monthly income. For example, if the borrower owes $1,500 in debt and $1,000 of it comes from a mortgage, while earning a monthly salary of $6,000, then their front-end ratio is $1,000 / $6,000 = 16.67%.
Unlike the back-end ratio, the front-end ratio comes with an upper limit of 28% for mortgages. The higher the ratio, the increase in the likelihood that the borrower will default on the mortgage, and vice-versa if the ratio is lower.
The debt-to-limit ratio is a metric that defines the amount of total available credit that is being utilized. Specifically, lenders use the ratio to measure whether or not the borrower is maxing their credit card limit. To calculate debt-to-limit ratios, find the balance of debt in each existing credit card and divide it by the approved credit limit.
Limitations of the Back-End Ratio
It is important to recognize that the back-end ratio is simply one of many metrics that can be used to understand the borrower’s ability to settle their debt. Lenders can analyze the borrower’s credit history and credit score to make a decision on whether extending or raising credit is worthwhile.
The back-end ratio does not recognize the different types of debt and service costs of debt. For example, although credit cards yield a higher interest rate than student loans, they are added together in the numerator within the ratio.
If the borrower transfers balances from a low-interest credit card to a higher one, evidently, the monthly debt payments will be higher. Thus, the back-end ratio should be higher as well. However, as the ratio sums all debt in one package, the total debt outstanding remains the same.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: