What is Back-End Ratio?
This is also known as a debt-to-income ratio. Back-End Ratio is used to determine how much of a person's salary would be used to clear his or her debt. It can also be used to check the debt limit a person can afford. Debt incurred at the end of a month often include mortgage payments such as interest, principal, taxes, and insurance, other debts include child support, credit card, and loans. As a result, the Back-End ratio is used by mortgage lenders to determine whether a potential borrower has enough income to pay off his or her debt.
Back-End Ratio is often calculated as Back-End Ratio = (Total monthly debt expense / Gross monthly income) x 100. Lenders calculate this alongside with the front-end ratio to determine if a person is qualified for a mortgage or not.
Breaking Down Back-end Ratio
Back-End Ratio is one of the metrics used by a lender to calculate the level of risk involved in lending to a borrower. This is very important because it is used to find out how much a potential borrower owes in another company. It would also help to find out the financial capacity of the borrower. If after the inquiry the lender finds out that a very high percentage of the potential borrower's income would be used to clear his debt, the borrower is considered to be a high-risk borrower. This is because a reduction in his paycheck or loss of a job would make his debts pile up in a hurry and take a while to clear. In such a situation, the potential borrower might lose the chance of obtaining the mortgage or be advised to reduce his debts.
How To Calculate The Back-End Ratio
Back-End Ratio is calculated by adding up all the potential borrowers' monthly debts and dividing this with the borrower's monthly debts. Take, for instance, a potential borrower earns $5000 per month and the total amount of his monthly debt is $2000. The borrower back-end ratio is 40% ($2000/$5000).
The most common back-end ratio is one that does not exceed 36%. However, some lenders allow borrowers with good credit cards to get up to a 50% back-end ratio. Other lenders use the back-end ratio together with a front-end ratio, while some consider the ratio when the borrower is applying for a mortgage.
How To Get Approval For A Back-end Ratio
The two major ways a borrower can lower his or her back-end ratio is by selling a financed car or paying off a credit card. However, if the home the borrower is applying for is one with enough equity, the borrower can take care of his other debt with his or her cash-out refinance. This would also help reduce the back-end ratio. Though cash-out resonance could lead to a greater interest risk, interest rate on cash-out refinance is often higher than a standard rate refinance because of the risk attached to using a cash-out refinance. The additional interest is used to compensate for the risk.
Added to this, most lenders often require that the lender close his debt account by paying off his or her debt in a cash-out refinance if otherwise, they would have to run the customers balance back up.