Qualifying for a Mortgage - How Lenders Evaluate a Home Buyer"s Income
The prospect of buying a home is a decision wrought with apprehension for most people. A working knowledge of the mortgage qualifying criteria is essential in relieving anxiety and having the confidence to begin the house hunting process.
Underwriting standards have become more stringent in recent years. In current mortgage environment, those who are approved for a standard fixed rate mortgage can be certain that the lender would not approve that loan if the documentation of income, assets and credit did not meet lending standards and therefore statistically affordable for the borrower. However, from a personal point of view every potential home buyer must make their own determination of affordability.
The first step in the home buying process is to secure pre-approval from a lender. This should be thorough evaluation of the borrower's credentials including a "complete" loan application (FNMA 1003 form) and a tri-merged credit report (includes all three repositories). Documentation of all income and assets must be provided. Technologically advanced lenders enter the borrower's documentation into their computer and their system provides an approval decision subject to a list of additional documents or conditions for final approval. Even with this approval the applicant should not feel entirely secure because the application will be further scrutinized. Once the contract to purchase the home is ratified by the buyer and seller and an appraisal of the property is secured by the lender, the application and the accompanied documentation is submitted to an underwriter for final approval. The underwriter's responsibility is to protect the lender from default and to insure that the loan is salable on the secondary market. Review of the documents submitted by the applicant frequently promotes questions that the automated system does not detect and must be addressed.
Income guidelines suggested by FNMA in qualifying for a mortgage are the industries accepted standard and are universally adopted by mortgage lenders. The basic underwriting criteria are centered on two ratios. The total mortgage payment including principal, interest, property taxes, homeowners insurance and mortgage insurance (if applicable) should not exceed 28% of the borrower's gross monthly income and the monthly mortgage payment plus minimum monthly payment on long term debt (as defined by the credit report) should not exceed 36% of the borrower's gross monthly income. These ratios are routinely "stretched" to as high as 35% and 45% for those who have "compensating factors" such as excellent credit, employment stability and exceptional assets.
The underwriter's risk mitigation will include an evaluation of the borrower's "ordinary" income and the probability that it will continue at the same level. For those whose entire income is derived from permanent employment, receive a regular paycheck documented by W2's and the two most recent pay stubs, and have a two year employment history there is not much to be concerned about as long as the income and debt ratios are in line with FNMA standards. A recent change in employers is not normally a problem as long as the position is in the same line of work.
On the other hand, self employment presents a complicated set of circumstances. Borrowers who own over 25% of a business are considered self employed. Underwriters require a two year history of income from the business documented by tax returns and a profit and loss statement signed by the corporate accountant for the current year. The borrower's personal income is derived by averaging the previous two years W2's plus year to date for the current year. For growth purposes, many small business owners take minimal income from their business even though the business may be prospering. This can present a problem because the underwriter can't use business equity to qualify the borrower since it is not classified as ordinary income.
If the borrower is a Sole Proprietor and declares business expenses on the individual tax return, those expenses that are deemed "re-occurring" will be deducted from the borrower's income. Usually that means that for qualifying purposes the underwriter will deduct all schedule-C business expenses from the gross income.
Commissioned employees must provide the previous two years tax returns for the underwriter to determine if business expenses such as transportation and supplies are deducted. Re-occurring business expenses will be deducted from the borrowers qualifying income.
Temporary employees and contract employees can also expect harassment from the underwriter regardless of length and consistency of employment with the same firm. The problem is that the probability of continued employment could be in doubt. The solution to this problem is a strong letter from the employer stating that employment "will" continue for the foreseeable future. The underwriter will also require a two year history of consistent income from that employer supported by applicants previous two years W-2s.
There are other sources of income that are acceptable for qualifying purposes such as part time employment, interest income on assets (those not used in the purchase transaction), inheritance income, etc. The test is that there is a two year history of the income and it is likely to continue for next five years.
If the process seems a little frightening, it is just a matter of thoroughly documenting ones income and asset's. Those who are contemplating a home purchase should be aware that they will need to have ready access to their financial documents and make sure their credit report is reasonably accurate.
It is obvious that a loan officer with underwriting knowledge and experience can be a great asset in preparing a borrowers application prior to underwriting submission. Most loan officers have a vested interest in securing the borrowers approval since they are commissioned. It is only the underwriter that sometimes seems like an evil spirit.
Underwriting standards have become more stringent in recent years. In current mortgage environment, those who are approved for a standard fixed rate mortgage can be certain that the lender would not approve that loan if the documentation of income, assets and credit did not meet lending standards and therefore statistically affordable for the borrower. However, from a personal point of view every potential home buyer must make their own determination of affordability.
The first step in the home buying process is to secure pre-approval from a lender. This should be thorough evaluation of the borrower's credentials including a "complete" loan application (FNMA 1003 form) and a tri-merged credit report (includes all three repositories). Documentation of all income and assets must be provided. Technologically advanced lenders enter the borrower's documentation into their computer and their system provides an approval decision subject to a list of additional documents or conditions for final approval. Even with this approval the applicant should not feel entirely secure because the application will be further scrutinized. Once the contract to purchase the home is ratified by the buyer and seller and an appraisal of the property is secured by the lender, the application and the accompanied documentation is submitted to an underwriter for final approval. The underwriter's responsibility is to protect the lender from default and to insure that the loan is salable on the secondary market. Review of the documents submitted by the applicant frequently promotes questions that the automated system does not detect and must be addressed.
Income guidelines suggested by FNMA in qualifying for a mortgage are the industries accepted standard and are universally adopted by mortgage lenders. The basic underwriting criteria are centered on two ratios. The total mortgage payment including principal, interest, property taxes, homeowners insurance and mortgage insurance (if applicable) should not exceed 28% of the borrower's gross monthly income and the monthly mortgage payment plus minimum monthly payment on long term debt (as defined by the credit report) should not exceed 36% of the borrower's gross monthly income. These ratios are routinely "stretched" to as high as 35% and 45% for those who have "compensating factors" such as excellent credit, employment stability and exceptional assets.
The underwriter's risk mitigation will include an evaluation of the borrower's "ordinary" income and the probability that it will continue at the same level. For those whose entire income is derived from permanent employment, receive a regular paycheck documented by W2's and the two most recent pay stubs, and have a two year employment history there is not much to be concerned about as long as the income and debt ratios are in line with FNMA standards. A recent change in employers is not normally a problem as long as the position is in the same line of work.
On the other hand, self employment presents a complicated set of circumstances. Borrowers who own over 25% of a business are considered self employed. Underwriters require a two year history of income from the business documented by tax returns and a profit and loss statement signed by the corporate accountant for the current year. The borrower's personal income is derived by averaging the previous two years W2's plus year to date for the current year. For growth purposes, many small business owners take minimal income from their business even though the business may be prospering. This can present a problem because the underwriter can't use business equity to qualify the borrower since it is not classified as ordinary income.
If the borrower is a Sole Proprietor and declares business expenses on the individual tax return, those expenses that are deemed "re-occurring" will be deducted from the borrower's income. Usually that means that for qualifying purposes the underwriter will deduct all schedule-C business expenses from the gross income.
Commissioned employees must provide the previous two years tax returns for the underwriter to determine if business expenses such as transportation and supplies are deducted. Re-occurring business expenses will be deducted from the borrowers qualifying income.
Temporary employees and contract employees can also expect harassment from the underwriter regardless of length and consistency of employment with the same firm. The problem is that the probability of continued employment could be in doubt. The solution to this problem is a strong letter from the employer stating that employment "will" continue for the foreseeable future. The underwriter will also require a two year history of consistent income from that employer supported by applicants previous two years W-2s.
There are other sources of income that are acceptable for qualifying purposes such as part time employment, interest income on assets (those not used in the purchase transaction), inheritance income, etc. The test is that there is a two year history of the income and it is likely to continue for next five years.
If the process seems a little frightening, it is just a matter of thoroughly documenting ones income and asset's. Those who are contemplating a home purchase should be aware that they will need to have ready access to their financial documents and make sure their credit report is reasonably accurate.
It is obvious that a loan officer with underwriting knowledge and experience can be a great asset in preparing a borrowers application prior to underwriting submission. Most loan officers have a vested interest in securing the borrowers approval since they are commissioned. It is only the underwriter that sometimes seems like an evil spirit.