Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Back-End Ratio

What it is:

Banks use the back-end ratio to determine whether a mortgage applicant is a good credit risk.

The formula for the back-end ratio, generally, is:

Back-End Ratio = (All monthly loan payments + requested loan’s monthly principal and interest payment + monthly property taxes on proposed real estate + monthly homeowners insurance premium)/Gross monthly income

How it works (Example):

For example, let’s assume John Doe wants to get a $500,000 mortgage that comes with a principal and interest payment of $2,400. The house costs $1,200 a year to insure ($100 a month), and the property taxes run $6,000 a year ($500 a month). John Doe also has $250 a month in student loan payments, and a $400 monthly car loan payment. John makes $120,000 per year, or $10,000 gross per month.

Using the information above, we can calculate that John Doe’s back-end ratio is:

Back-End Ratio = ($250 + $400 + $2,400 + $100 + $500)/$10,000 = 36.5%

Why it Matters:

The back-end ratio is a way to evaluate a borrower’s credit risk. Many lenders use the ratio instead of or in conjunction with the front-end ratio, which also evaluates a borrower’s financial obligations in relation to his or her income (but is less conservative than the back-end ratio). Many lenders have a rule of thumb that a borrower’s back-end ratio should not exceed 36%, though a borrower with good credit puts lenders a bit more at ease in special cases.

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