Back-End Ratio: Definition, Formula & Example

Understand

The back-end ratio or debt to income ratio is used by lenders to check credit worthiness or an ability of a borrower to pay back debt. Or It tells how much of dollars you have left, after paying principal and interest expenses of currently prevailing loans, to pay for a fresh loan.

The formula to calculate back-end ratio is:

Back-End Ratio = [Total Monthly Debt Expenses / Gross Monthly Income] * 100

Example

Suppose you want to get a loan of $100,000 for one year with principal and interest of $9,000 per month. Currently, your monthly income is $20,000 and monthly debt expenses are:

Monthly car loan installment = $4,000

Study loan installments a month = $800

Your back-end ratio will be = [(4,000+800) / 20,000] * 100 = 24%

This means that 24% of your monthly gross income is being utilized to pay back loan expenses, if the higher percentage of monthly gross income is used to pay debts, the lender will consider the applicant high risky. As a rule of thumb, the applicant will be considered low risky if the ratio is below 36%.

Importance

Before lending money, lender like any bank has strong credit policies like checking credit worthiness of an applicant to secure wealth of its shareholders. The back-end ratio is one tool to understand level of risk associated with pertinent applicant.

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