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.