When Lenders Think You’re Self-Employed
You might very well be self-employed and don’t even know it…at least in a mortgage lender’s eyes. How so? There are various types of income borrowers can have that don’t quite fit in the same box as others. One of the more important elements of a mortgage approval involves comparing monthly debt with monthly income. This comparison is made with what is called a “debt to income” ratio, or simply “debt ratio.” There are two such ratios used with most loans. The first ratio is sometimes referred to as the housing ratio, or front ratio. This number is somewhere around 33 or so. If gross monthly income is $6,000 per month, then the mortgage payment, which includes a monthly amount for property taxes, insurance and mortgage insurance if needed, should be around 33 percent of $6,000, or $1,980. There is a bit of “wiggle room” here but this is a common debt ratio.
The other ratio considered is the total debt ratio, or “back” ratio. For most loans, this ratio is at 43, or 43 percent of gross monthly income. Again using the same example, total monthly credit obligations should be somewhere around 43 percent of $6,000, or $2,580. By subtracting the housing allotment of $1,980, that leaves $600 available for other debt such as a car payment, credit cards or other loans. Again, different loan programs may have a different ratio requirement and the ratio also allows the lender to make its own determination. If the total debt ratio is say 45, the lender may still approve the loan based upon other positive aspects of the loan file such as high credit scores or larger cash reserves.
How do lenders calculate income? It’s relatively easy to do by simply reviewing pay check stubs covering a 30 day period. These pay check stubs will show a gross amount of income along with all withholdings. Lenders ignore the withholding amounts and use the gross amount. There will also be a year-to-date amount which should match up with the monthly figure. For instance, if a couple together makes $10,000 per month and it’s the end of July, the year-to-date amount should be around $70,000. The lender will also ask for your last two years of W2 forms which will provide evidence of at least two years of employment, a common lending requirement, as well as annual totals. Lenders will compare the W2 amounts with recent pay check stubs for consistency.
But there are many other types of income that may be used to help qualify. Besides base employment income, there may also be overtime income. Bonuses, commission, dividends and interest and rental income can also be considered provided the income meets lending guidelines. Typically, any income beyond base income must show at least a two year history, be consistent while the lender makes the determination the additional income will likely continue into the future. How can a lender make such a determination? How can a lender know that other income will continue well into the future?
Obviously the lender can’t accurately predict the income will continue but if the borrowers do show a two year history of receiving the income the lender could reasonably determine the income will continue as there is a consistent history of receiving it. For example, when someone is paid hourly and that person is paid for a 40 hour work week and double-overtime for anything beyond 40 hours, if the overtime is consistent, it can be used. If not, then it might not qualify. It’s easy for a lender to calculate overtime income by reviewing pay check stubs which will have the base amount plus overtime. W2 forms will also show total income and the lender can break out base pay and overtime pay.
Dividend and interest income must also meet this threshold. Bonuses and commission income is treated in the same fashion. However, if the income isn’t consistent it can’t be used. Take bonus income for example. Bonus income is typically issued after an employee achieves certain goals, such as opening up new accounts or surpassing sales expectations. If an employer pays a quarterly bonus based upon performance and the employee shows bonuses paid every quarter, it’s likely the bonus income can be used.
You might work for someone else but a lender can evaluate your loan application in the same manner as when reviewing an application for a self-employed borrower. How so? When commission or bonus income exceeds 25% of your total monthly income. If for example your total monthly income is $8,000 but your monthly commissions average $4,000 per month, you’re underwritten a bit differently.
Lenders will ask for two years of federal income tax returns. Lenders will review the returns to match up the income listed on the loan application. Lenders will also look for any unreimbursed employee expenses. If such expenses are listed on Schedule C of the returns, those amounts must be deducted from gross monthly income. For example, an employee shows $5,000 in the past year of travel and entertainment expenses. This amount must be deducted from gross income for qualifying purposes.
This is how self-employed borrowers are underwritten. A self-employed borrower lists gross income but must also list the expenses associated with earning those amounts. If a business has an annual gross income amount of $100,000 but also lists $20,000 in travel and entertainment expenses, the qualifying income is $80,000, not $100,000.
If you do receive such income or any other type of income not coming from an employer but you think you need the additional income in order to qualify, first speak with your loan officer who can review your documentation for you and arrive at a qualifying amount. In this fashion, you’ll have a preapproval letter in your hand and you can shop with confidence, knowing your tax returns, pay check stubs and W2 forms have already been reviewed and approved by your lender. Other types of income can require a bit more documentation, but as long as there is a consistent history of at least two years, it can be used.