One of the key components when lenders evaluate a loan application is affordability. Lenders consider current monthly credit obligations such as an auto loan and credit card payments and add those to the new mortgage payment. The new mortgage payment includes principal and interest, property taxes, insurance and mortgage insurance when required. This total is then compared with gross monthly income. Most loan guidelines ask that monthly debt payments be somewhere around 40-43 percent of all the income listed on the loan application. But not all income can be used when qualifying for a mortgage.
For those who are employed and get a pay check on the 1st and 15th of each month, loan guidelines will ask for copies of recent pay check stubs to verify monthly income as well as a year-to-date amount. Income and employment is also verified by looking at the last two years of W2 statements. This third party verification system allows lenders to use employment income to help qualify. For someone that is self-employed, lenders will want to look at the last two years of federal income tax returns, both personal and business.
Business income must be consistent from one year to the next. Lenders do understand that business income can ebb and flow over time so some differences will be expected from one year to the next. To calculate business income, lenders add the net income for both years and then average that amount by dividing the total by 24 (months). What lenders want to see is consistent income. A red flag pops up when there is a decline in income from one year to the next. Granted, there can always be income fluctuations but when the income is say more than 10% lower than the previous year, the lender may request a letter of explanation from the borrower explaining the reduction in income. Typically that’s all that’s needed in order for the loan to move through the approval process but when there is a precipitous drop, such as 25 percent or more, without a solid explanation the loan could be turned down.
Any income that is listed on the loan application can be used as long as there is at least a two year history and there is a determination made the income will likely to continue into the future. With a two year, consistent history of income verified with tax returns the income can be used. Such income might be bonus income, or interest and dividends.
Yet there are times when applicants complete a loan application and the lender informs the applicant that even though the income is there, it can’t be used. How can that happen when someone can clearly provide evidence the income was deposited in a bank account?
Let’s look back at those bank statements for a moment. Recall we mentioned lenders pairing up deposits with pay check stubs? Someone that got paid on the 1st and 15th should show income on or around those dates that match what’s on the pay stubs. But what if there’s a deposit that shows up on the 20th that doesn’t match anything that appears on the pay stubs? The lender will want to know the source of those funds before it can be used as income. Is it a loan from someone? If so, what are the payment arrangements? Did the applicants sell something they owned? Maybe there was a garage sale held and they made out with another $500. While a lender can use this $500 to help with closing costs it’s not considered income but a one-time event.
What about someone that took up a part time job to help out with bills around the house in addition to their current job? That income might be used but again unless there’s a two year history of that part time income it can’t be counted. The recurring theme here is a two year history and a likelihood of continuance. Regardless of the source, qualifying income must follow this standard.