Front End Debt Ratio vs. Back End Debt Ratio
Original post by Phil Altshuler of Demand Media
Debt ratios determine if a potential borrower qualifies for a mortgage loan. A lender sets maximum allowable ratios based on current economic conditions and desired level of risk. When credit is tight, a lender will lower the maximum debt ratio he will accept. When the economy improves, he is willing to take a slightly higher risk to maintain his market share, so he will increase his allowable debt ratio.
Debt ratios are a calculation based on your monthly expenses as a percentage of your monthly income. Higher ratios increase the probability that you will default on your credit obligation. When subprime mortgages were common, back-end ratios of 50 percent, and in some cases 55 percent, were acceptable. In 2011, lenders are looking for back-end ratios of 38 percent or less. Some conservative lenders will not approve loans with ratios over 33 percent.
The front-end ratio is determined by dividing the total of your housing debts by your gross monthly income. Housing debt consists of the monthly principal and interest payment of your proposed loan plus your estimated monthly property tax and homeowners insurance. If there is a homeowners association, monthly dues are also included.
To calculate your back-end ratio add any additional fixed monthly obligations you have to your proposed housing debt, and divide the total by your gross monthly income. Monthly obligations consist of minimum payments due on credit card balances, installment loans, vehicle loans or lease payments, student loans and other recurring credit obligations. If an installment obligation has less than 10 months remaining, it is not included in the calculation, except if the vehicle is leased. Lenders expect you to lease another vehicle when your current lease expires.
Lenders often exceed their debt ratio guidelines if you have compensating factors, such as exceptional job stability or large cash reserves. For example, if you have been employed at the same company for 20 years, or you have liquid assets equal to two or three years income, there is a low probability that you will default on your loan, and you are considered less of a risk.
- The Federal Reserve Board; Home Mortgage: Understanding the Process; June 2001
- Department of Corporations: 20 Questions to Ask a Lender or Mortgage Broker
- Mortgage Loan Requirements and Eligibility Criteria
About the Author
Phil Altshuler has written award-winning ad copy and sales-training literature since 1965. He is an expert in conventional and sub-prime loans, bankruptcy, mortgage loan modifications and credit. Altshuler was a licensed mortgage broker in California and Arizona, as well as a licensed electrical contractor. He has a Bachelor of Science in electronic engineering from California Polytechnic State University.