Underwriting Guidelines – Income Considerations

While basic understanding of the “book smarts” within the mortgage industry will help you understand specific terminology, loan programs, and features, there is so much more you will need to know in order to make an informed financial decision.

My approach to providing education strives to further your understanding beyond the “book smarts” of the mortgage industry, and learn the valuable “street smarts” that will help you achieve the best possible results, while avoiding the most common pitfalls that non-informed Borrowers and Real Estate Professionals have experienced.

The Mortgage Street Smarts of what is considered regarding a Borrower’s income on a Loan Application:

Lenders across the country are constantly revising and updating the underwriting guidelines used to determine whether a Borrower will be approved on a loan application. The following information pertains to “income considerations” that an Underwriter will review when considering the “capacity” of a Borrower to earn income (and the subsequent likelihood that they will pay back their new loan).

W2 Employees – Full Time

• Consider 2 years of past employment in either the same industry or same line of work
  • Multiple fields of work appear to show instability in work commitment as well as likelihood of lateral or downward mobility
• Are there multiple gaps in employment?
  • This will often require a Letter of Explanation (LOE) if the gap is more than 30 days unless the level of position is Manager/Executive, or if their expertise is in a distressed industry
• Are employment changes due to upward mobility?
  • More leeway is given if income continues to increase as a result of job changes
• Umemployment benefits will be used as income for the purposes of qualifying only if the job is considered seasonal (i.e. fire fighter, construction worker, farm worker, etc.)
• No substantial changes in employment 90 days prior to completing the loan transaction
  • It is important to note that the Lender will typically conduct a Verification of Employment (VOE) on the day of funding (and not just when the application is initially underwritten)
• Does the Borrower’s income consist of more than 25% bonuses or commissions?
  • Tax returns will need to be reviewed to show offsetting business-related expenses (entertainment, travel, etc.)
  • Business-related expenses will be averaged over a 24 month period (if income is increasing) or a 12 month period (if income is decreasing)
• Full-time higher education can be included in fulfilling the 2 years of employment requirement if work history and educational history are in related fields
• Employed by a relative: more emphasis will be placed on tax returns, W2 forms, and paystubs (as opposed to verbiage on a written Verification of Employment (VOE) form) due to the possibility of a potential bias from the “interested party” (relative)

W2 Employees – Part-Time and/or 2nd Job

There are many reasons why a Borrower may have a 2nd job or a part-time job. Important factors to consider include:

• Is there a 2-year history of this type of employment within the same industry or line of work?
• What is the likelihood that this employment/income will continue in the future?

Self-Employed Borrowers

Does the Borrower have ownership of 25% or more of the business? If so, they are considered Self-Employed Borrowers. Given that self-employment comes with a higher level of uncertainty with regard to continued income (and therefore represents a higher risk to the Lender), the Borrower will be required to supply additional income documentation over the most recent 2 year period.

• Among the information that an Underwriter will likely review include (but are not limited to): the company’s Business License, website, and whether the state of incorporation is in good standing
• Individual Federal Tax Returns for the previous 2 years to determine the average monthly income
• Business Tax Returns (i.e. 1120’s, K1’s, etc.)
• Financial Statements within 120 days of loan transaction
  • Year-to-Date (YTD) Profit & Loss statement (P&L) will be reviewed to determine if current year’s income is consistent with previous year’s earnings
  • Lender will need to confirm the financial strength of the business and its likelihood to continue to generate the necessary income
  • Certified Public Account (CPA) letter may be used to verify the validity of the provided documentation (and age of Business)
• How long has the Company been operating?
  • Minimum requirement is 2 years in same industry
  • If less than 2 years, the company may be considered on a case-by-case basis (but the probability of an approval is low)
  • May need to document the likelihood of continued success through feasibility studies and/or pro-forma financial statements
• Analysis of whether Company’s income has increased or decreased over the most recent 2-3 years
  • Are the reasons for increase or decline due to factors not related to the business (i.e. capital gains for the sale of real estate) unless it is characteristic of the business (i.e. real estate flipping)
• Does the Borrower withdraw cash from the Company?
  • This is important to ensure that this will not have a negative impact on the cash flow and/or stability of the business
• Any salaries, draws, and/or add-backs received by Borrower may be added to the net profit, but only the proportionate share of these profits may be used to qualify
• Projected income may not be used for qualifying purposes unlesss consistent with previous documented earnings history
• In order to add after-tax corporate earnings to the Borrower’s income, their percentage of ownership and rights to the funds must be verified (via IRS form 1120 – Corporate Federal Tax Returns)
• In order to qualify, the Borrower’s income will be calculated and their proportionate percentage of depreciation and amortization expenses will be added back.
  • Particularly important for industries with expensive machinery (i.e. Dentists, Printers, etc.)

Passive Sources of Income

For each of the following Passive (unearned) Incme sources, the general rule is that the following minimum requirements must be met:

• 2 year history verifying receipt of income
• Minimum 3 years of continued income from each source
• Verification of tax returns (or other 3rd Party documentation)
  • Court documents
  • Legal settlement agreement
  • Brokerage Firm statements
  • Cancelled checks or receipts (6-12 months)
• Alimony
  • Is there a termination date specified (until marriage, death)?
• Child Support / Foster Care
  • The age of the children will be reviewed (to determine the length of continued receipt of income)
  • If Marital Settlement Agreement states income received through “child’s” college, proof will be required that child is over 18 and enrolled in college (higher education)
• Interest/Dividends/Retirement
  • Does the Borrower still own these assets (are they still invested and not yet liquidated)?
  • If interest or dividends are increasing, an average of 24 months will be considered
  • If interest or dividends are decreasing, an average of 12 months will be considered
  • State of the economy is considered (and current market rate may be assumed for valuation purposes)
• Social Security
  • Based on the death of a minor’s parent?
  • If so, how old is the child for the purposes of the income continuing for 3+ more years?
• Rental Income
  • Tax Returns will be required
  • Automatic 25% expense ratio (also referred to as a “vacancy factor”) taken off gross rental income
  • Net rental income = Gross rents minus actual expenses (not counting depreciation)
• Capital Gains Income (i.e. Real Estate, Stocks, Bonds, etc.)
  • One-time capital gains are not considered income
  • If there is a 3 year history of recurring capital gains, 3 years of tax returns must be reviewed
  • Average of 24 months is calculated to prove/document monthly income
  • Do assets currently exist under Borrower’s ownership?

Non-taxable income (i.e. child support, alimony, foster care, some portions of military or social security income) are typically “grossed up” to 125% of their value.

• What this means is that since these types of income are not taxed, that income is worth more than traditional income that would be subjected to an average of 25% income taxes withheld
• Example: $1000 monthly Social Security income x 125% = $1250 income used to qualify

Maternity/Paternity Leave, Worker’s Comp/Medical Leave

• These types of income are considered “temporary disability” and they do not have the likelihood that they will continue.
• Therefore, this income will not be considered to qualify
• Documentation requirements for the purposes of explaining income decrese and likelihood of future income include:
  • Borrower’s letter of intent to return to work
  • Employer letter confirming Employee will be hired back to the same position at the same pay rate
  • Letter from Physician indicating anticipated date of release and eligibility to return to work
  • Date of return to work should be prior to the first mortgage payment due date

For more information on topics like this, please feel free to visit www.MortgageStreetSmarts.com (an educational resource for Borrowers, Real Estate Agents, and Financial Professionals)

To see if you qualify (and to obtain a current market interest rate quote), click here for a secure online loan application form.

(Content provided by Jason E. Gordon NMLS #259027)