Back-End Ratio

What Is the Back-End Ratio?

The back-end ratio is one of the common financial metrics utilized to evaluate an individual's ability to manage debt obligations.

The back-end ratio, also known as the back-end debt-to-income ratio, is a key metric used by lenders to study their clients' riskiness. It mainly identifies how much of a client’s monthly gross income is used to settle their overall monthly debt payments. 

If a client shows a high back-end ratio, it means much of their gross income is going towards covering debt, which means they are less likely to manage their payments. In other words, it shows a risky client. 

On the other hand, a low back-end ratio shows that debt payments are a small portion of a client’s income. In this case, the client's risk of mismanaging their debt payments is low.

Lenders usually look for a back-end ratio of less than or equal to 36%. However, if a client shows an outstanding credit history or backup savings, the accepted percentage may increase up to 50%.

To calculate this ratio, you need to divide a client’s total monthly debt payments by their monthly gross income:

Back End Ratio = Total Debt Payments / Monthly Gross Income

Back-End Ratio Practical example

Let’s dive into a practical example to illustrate how the ratio works. You’re an analyst at Citigroup and you were asked to assess the riskiness of Sam, a new client applying for a personal loan.

Sam works as a teacher and earns $4,000 monthly. Sam has a couple of monthly debt payments:

• Credit card bills: $500
• Student loan: $200
• Mortgage loan: $600
• Other loans: $300

Thus, the total debt payments for Sam are $1,600 per month.

Following the formula provided above

Back-End Ratio = Total Debt Payments/ Monthly Gross Income

we can calculate the ratio of Sam’s debt payments to his monthly income:

Back-end ratio= 1,600/4,000= 40%

As most lenders desire a maximum ratio of 36%, you should not approve Sam’s application since his back-end ratio exceeds your requirements by four percentage points. In other words, Sam may be a risky borrower due to his high debt payments.

If Sam loses his job for any reason, his debt will accumulate over the months, leaving him unable to finance his loan payments. 

How to Lower the Back-End Ratio

There can be a few ways we can lower the back-end ratio of an individual. Some of them are as follows:

1. Increase your monthly gross income: One of the ways we can lower the ratio here is to increase the gross income. This can be achieved by moving a job to a better-paying corporation, negotiating for a raise, taking up a part-time job, or developing a side hustle.
2. Decrease your monthly debt payment: Paying debts on time and maintaining interest payments will significantly lower the back-end ratio. Shifting focus on paying the high-interest debts will also contribute positively.
3. Avoid taking new forms of debt: If any individual seeks to keep their back-end ratio low, there should be attempts to avoid taking on new debts. This could be in the shape of avoiding any credit card purchases and purchasing a new property. 
4. Make attempts to reduce expenses: The expenses should be consistently monitored, and attempts should be made to reduce the overall monthly and yearly expenses. This can be done by renegotiating bills, reducing discretionary expenses, and looking for better alternatives.
5. Increase savings: Building up savings can positively impact a person and provide a financial buffer that reduces their reliance on credit and debt. 

Let’s use Sam’s example illustrated above to assess the efficacy of these ways to reduce the back-end ratio.

Scenario 1

Mathematically speaking, income is the denominator of the ratio, so the more it increases, the lower the ratio is going to be. 

From a practical side, Sam will be earning more with his debt staying the same, so the debt will contribute to a lower fraction of his income, and he will be able to afford more debt payments.

Let’s say Sam was able to contribute an additional $1,000 in monthly income by working extra hours as a tutor. His back-end ratio will drop to 32%. This will strengthen his loan application since his new ratio is below 36%.

Scenario 2

Looking at the formula, decreasing total debt payments, which is the numerator of the formula, decreases the ratio. 

In real life, any decrease in debt payments will liberate cash to be used in other activities.

Let’s say Sam could decrease his loan debt by $200. Also, he was able to decrease his mortgage payment by $100 by a cash-out refinancing of his mortgage. 

Thus, Sam’s new total debt payments became $1,300. In this case, the back-end ratio will decrease to 32.5%, strengthening Sam’s loan application.

Scenario 3

Imagine if Sam could make both approaches. His new income would be $5,000, and his new total debt payments would be $1,300. In this case, the ratio will decrease dramatically to 26%, making his loan application excellent.

Limitations Of Back-End Ratio

To understand the ratio better, it's important that we go through the limitations of it. There are only a few of them, but they come as they are inherent to the nature of the back-end ratio metric.

1. Simplistic View Of Debt: One of the ratio's primary limitations is that it considers all debt obligations as one. There is no clear distinction between high-interest-bearing debt (credit card) and lower-interest debt (student loan). This oversimplification can affect an individual's assessment of their financials.
2. Not Accounting For Types Of Debts: Different types of debts have distinct impacts on the financial position. The effect of credit cards will be quite different when compared to the effect of student loans.
3. Inflexibility In Calculations: The formula of the back-end metric ratio doesn't incorporate different elements like savings, assets, other sources of income, and more in its calculations. 
4. Thresholds May Vary: Lenders' most accepted threshold is 36%, but this may vary. Some lenders may accept a ratio of 50% with exceptional credit.
5. Lack Of Context: The ratio does not account for the variations in the metric. The metric may ignore factors like emergency spending, emergency debt, illiquidity, and other such factors.

What Is Front-End Ratio?

The front-end ratio also assesses the riskiness of borrowers, but it is specific to only one kind of debt. It focuses only on mortgage payments.

Similar to the back-end ratio, the front-end ratio shows the percentage of one's gross income going toward mortgage payments.

Front-End ratio = Monthly Mortgage Payments / Monthly Income

Lenders use the front-end ratio to measure the riskiness of potential borrowers. Like the back-end ratio, lenders desire a low front-end ratio, reflecting a borrower's ability to manage incremental mortgage payments. 

Most lenders desire a front-end ratio that is lower or equal to 26%. However, borrowers' requirements may increase accordingly if a client shows outstanding credit records or high net worth.

If you wish to decrease your front-end ratio, you may either decrease your monthly mortgage payment or increase your income. As we mentioned in the previous section, Sam may decrease his mortgage payments by refinancing his mortgage or by looking for ways to generate extra income.

Going back to Sam's example, his front-end ratio would be calculated by dividing his mortgage payment by his monthly income:

$600 / $4,000= 15%

It is crucial to mention that, given how much the front-end ratio ignores, lenders usually prefer to rely on the back-end ratio to assess their borrowers, as it shows a broader picture of their borrowing abilities.

Back-End Vs. Front-End Ratio

One popular financial indicator used to assess a person's capacity for managing debt is the back-end ratio. Whereas, the front-end ratio is also a popular metric that takes only the mortgage payments into consideration when assessing an individual's capacity to satisfy its mortgage obligations.

There are a few differences between the two. Let us see below.

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