The back-end ratio measures the debt against a borrower’s personal income to help lenders assess whether a loan can be approved, and if yes, at what amount.
This ratio is one of the various formulas and equations that lenders use to evaluate the borrowers’ affordability, in particular debt versus income, when applying for loans and credit facilities.
The resulting figure basically shows a screenshot of the percentage of debt against an individual’s qualifying income.
Because of this, it is also often known as the debt-to-income ratio which should not be confused with the debt ratio.
For example, it might be worked out this way:
Monthly income of $4,500
Minus $500 auto loan
Minus $400 personal loan
Minus $1,000 mortgage requested
Back end ratio equals $1,900/$4,500 = 42.22%
This helps a lender determine if a borrower might be taking on a loan that is way above his budget.
For example, if a lender is only comfortable with a back end ratio of 35%, then the maximum amount the lender would allow this particular applicant to use for debt servicing is $4,500 x 35% = $1,575. So the lender would probably approve a loan size calculated using $675 ($1,575 – $500 – $400) as the monthly mortgage payment.
This would also be limited by LTV.
However, it must be noted that even if the requested monthly mortgage liability is reduced, it does not necessarily mean a reduction in approved loan quantum as other factors might come into play.
For example, the borrower might still be able to obtain the required loan size if he takes on a longer term for the home loan.