Get Your Back End into Shape
Back end ratios are used by banks to make loan decisions. What can you do to improve yours?If you are applying for a loan, your debt-to-income ratios, especially your back-end ratio, are very important. We’re going to give you a quick overview of the subject so you’ll understand debt-to-income ratios and how they factor into lending decisions.
What is a back end ratio?
- The “back-end ratio” is the portion of your monthly income that goes toward monthly debt payments. The ratio is calculated against your monthly income as a percentage.
What debts are included in the calculation?
- In a back-end ratio, your monthly debt includes credit card, mortgage & auto loan payments, as well as child support and other loan obligations.
- A back-end ratio is different from a front-end ratio due to the debts included. The “front-end” ratio is only the ratio of your mortgage payment to your income. So for example, if you earn $48,000 per year, your monthly income is $4,000. If your total mortgage payment is $1,000, your front-end ratio is 25%.
- In that same scenario, if your total debt payments are 1,800 ($1,000 for mortgage, $350 auto loan, $300 credit cards, $150 student loan payment) your back-end ratio is 45%.
- Your total debt-to-income ratio or DTI, would be expressed as 25/45 (front/back).
How do lenders use this calculation?
- Some lenders consider only the back-end ratio, and give no weight to the front-end ratio when granting mortgage loans. Debt-to-income ratios are a very important factor in the lender’s decision, along with the borrower’s credit score, income, work history, the property being purchased, and more.
- The back-end ratio is more conservative than the front-end. That is, lenders with tighter lending standards are more likely to look at the back-end rather than the front.
- Lenders have criteria that they enter into the loan negotiation with. Generally, lenders strive to grant loans with a back-end ratio of 36% or lower. So in the example we listed above, with a back-end ratio of 45%, the loan would probably not be approved. Some lenders will make exceptions if the borrower has good credit, allowing ratios of up to 50%.
- Lenders who look at both the front and back end ratios might specify that they require a particular ratio, like 28/36. FHA loan limits are 29/41. VA loans only look at the back-end, which needs to be 41% or lower.
How can you improve your back end ratio?
- Because your debt-to-income ratio is just as important as your credit score to mortgage lenders, improving your ratio is important to ensure that you can get the loans you need, and also to guarantee that you’ll be able to afford your loan payments after the loan is approved.
- Paying down debt is the number one way to reduce your back-end ratio. If you can pay off credit cards and stop incurring new revolving debt, that will help your ratio greatly. In the scenario we listed above, if you paid off your credit cards, you’d be left with $1500 in monthly payments ($1000 mortgage, $350 auto loan, $150 student loans.). With $4000 in income, the new back-end ratio will be 37.5%. That is much closer to the desired 36%, and with a good credit score, may even be approved by most lenders.
- Increasing income also improves the ratio. Say that in our example, you get a 3% cost-of-living raise. Your new monthly income of $4,120, coupled with your $1,500 in monthly debt payments, gives you a back-end ratio of 36.4%. This ratio is much more likely to get your loan application approved.
- Decrease your mortgage payment to improve your ratio. If you make a larger down payment, opt for a 20 or 30-year mortgage instead of 15, or shop for a more affordable property to buy, you can lower your payment and make both your front and back end ratios lower. Getting more affordable insurance helps here too, since your mortgage payment includes PITI (principal, interest, taxes, and insurance).
Is there a counseling service available to help?
- Because paying down debt is the most common thing that home buyers need to do to improve their debt-to-income ratios, debt counseling is a great option to improve your back-end ratio.
- Debt counseling can help you reduce your monthly debt payments while putting you on a payment plan to completely eliminate your debts on schedule.
- If you have too much credit card debt, credit counseling can help you focus on those debts to improve your ratios. Consolidating your monthly credit card payments makes it easier and faster to become debt free.
- If you’ve already applied for a loan and been denied, call our Loan Denial Hotline for immediate help.
- If you have had recent or income problems, or have lost a home to foreclosure, the FHA’s Back to Work—Extenuating Circumstances Program can help. Check out our Back to Work Program for all the counseling and assistance you’ll need.
- Call us today at 800-294-3896 for free, confidential counseling and debt help.