There are three main components to qualifying for a home loan: credit, income, and assets. Every mortgage loan program has specific methods for calculating qualifying income.
Calculating the qualifying income for a mortgage can tricky. This is because of the myriad of business industries, ownership structures, and compensation methods. The qualifying income is used in the debt-to-income (DTI) calculator to determine how much home someone can purchase.
Qualifying Income Overview
Often times the qualifying income calculated for the loan approval may not be indicative of the actual earned income. This discrepancy can be a result of the income’s source, structure, history, or projected continuance.
The information below is to serve as a guide to how the mortgage industry considers income. This is not meant to be used as tax advice or instruct someone how to “work” the system.
In all cases, the gross income – i.e. the pretax income – is used as qualifying income. This seems odd considering that bills are paid with the net income that is deposited into the bank; however, that’s how the mortgage industry thinks.
As always we encourage (and welcome) you to call us if you have any question as we’re happy to help.
Employee vs. Self-Employed
There are various types of self employment structures. Check out the self-employment income analysis for more information on how the qualifying income is determined for the self-employed.
Someone is considered self-employed if they own 25% or more of a business (regardless of how they are paid). For example, a self-employed individual that receives a W2 from their company is still considered self-employed.
The mortgage industry considers someone self employed even if they don’t own a business. Someone that works on a per-job basis, or on a contract basis, is treated like a self-employed individual.
The history, consistency, and projection of pay are critical for self employed income. Most (but not all) mortgage programs will require a two year history of income, with the likelihood of a three-year continuance.
Moreover, the self employed qualifying income if often determined by using a two-year average, or a recent profit-and-loss statement, whichever is lower.
There are bank statement programs and other non-qualified mortgage options for self employed borrower. These programs will use bank deposits to determine income rather than the net income from tax returns.
Employee’s Qualifying Income
Employees of companies receive W2 income. If someone doesn’t receive a W2 then the mortgage industry calculates that qualifying income using the self-employed income analysis.
Calculating the qualifying income for a salaried employed is fairly straightforward. Take the gross annual salary amount and divided it by 12 months.
There are loan programs where a salaried employ can close on a home loan before actually starting with the new employer. This is done with the stipulation that the borrower will provide 30 days of paystubs within 60 days after closing.
Conversely, a few mortgage programs may require that someone be employed for six months before using that pay as qualifying income. This occurs when the employee was unemployed for six consecutive months prior to the current job.
Calculating the qualifying income for an hourly employee can vary depending on the history and consistency. Generically, the income is determined by multiplying the hours worked by the hourly rate.
What makes hourly income tricky is when the hours work are inconsistent. For example, determining the qualifying income will require further due diligence if someone works 25 hours in one week, 40 hours in another week, and 34 hours in a third week.
Variable Income (Commission, Bonus, and Overtime)
A two-year average will most likely be required to determine the qualifying income for commission, bonus, or overtime pay. Some programs do allow a 12-month average to be used for the income types.
If the income is declining from year to year, the qualifying income will be the most recent year’s income to be conservative.
- Social Security,
- VA Disability,
Income that is consistent, and likely to continue for at least three years, can be considered as stable income. Note: the income must continue for three years from the first payment date of the loan; not the date of closing and funding.
The pre-tax amount and if you receive the money tax-free then you can gross up that amount equal to your tax bracket.
Alimony, Child Support, and Separated Maintenance
Income from alimony, child support, and separated maintenance can be used as qualifying income. Like the fixed income category above, qualifying income from these sources must continue for three years from the first payment date of the closed loan.
These types of income also require a 6 to 12 month history of on time payments. Because this income is derived from from another person, the stability of the income needs to be verified with a history of payments.
Documentation for the Qualifying Income
The amount of documentation required when qualifying for a mortgage is dependent on the loan program.
Automated underwriting systems also impact what type of paperwork is needed. Many times the personal tax returns may not be needed. Conventional loans for W2 employees often don’t require tax returns.
Below are the sections of a personal tax return and a brief description of the income associated with each schedule.
1040 Personal Tax Returns
There are many schedules to a personal tax return. The type of income earned determines what schedules are included.
Schedule A / 2106 Unreimbursed Business Expenses – the Schedule A shows the expenses that are itemized on the 2106 Form. There are instances the qualifying income is reduced by the Schedule A losses.
Schedule B – this is interest and dividend income. The vast majority of the time this income will not used as qualifying income. The reason is because this income often doesn’t have a history or projected continuous (or isn’t enough to impact the approval).
Schedule C – this is for sole proprietors that are self-employed. Check out our Schedule C calculator to determine the qualifying income.
Schedule D – this is for capital gains and most often won’t be considered as income or as a loss. The gains and losses from the sale of equities (like stocks) will show up here.
Schedule E, page 1 – this is for Real Estate Owned (REO) and royalties. The qualifying income (or losses) from this section may impact the purchasing power. Check out our Schedule E details for more information on what to use for income.
Schedule E, page 2 – this is where business entities (like LLC, S-Corp, C-Corp, and Partnerships) flow to the personal tax return. A self-employment income analysis will need to be completed to determine the qualifying income.
Schedule F – this is farm income generated by farming or ranching. This is rare and not often used for qualifying for a home loan because of the inconsistency in income.
Below is an outline of the types tax documents and tax schedules found in the income tax returns along with a brief description of each. Hopefully this provides insight why our Document Checklist is so extensive and why it’s so detailed. You’re welcome to use our DTI calculator to see how much home you can afford once you get an estimate of your qualifying income.
For the 1099 or the contract employee, the qualifying income will require tax return evaluation. A very conservative approach would be to use the net income reported on the tax returns.
Typically 30 consecutive days of paystubs are required to document qualifying income. Again, these must be 30 consecutive days. Additional documentation may be required if the year-to-income (YTD) income isn’t consistent with the income structure. Moreover, additional documentation may be required if there are debt obligations being withheld (like child support or a 401k loan).
W2s are required even when tax returns are provided. The reason is because the W2 shows the employee and employers.
For example, a personal tax return may show $100,000 in annual income; however, it doesn’t breakdown that $30k came from one employer, $20k came from another employer, and the final $40k came from the spouse.
The documentation for self-employed borrowers can be extensive. The documentation requirements may be reduced if someone has been self employed for longer than five years.
The following is the documentation required for the self-employed that own entities. This is the income that
Business Tax Returns
Most loan programs require two years of business tax returns. The qualifying income will be calculated on a variety of factors. The final result will be a combination of the net income and potential add-back line items.
A K1 tax form is like a W2 for a self-employed person. It shows the income dispersed to the business owner. K1s are issued regardless of the percentage of ownership.
Profit and Loss Statement
A Profit and Loss Statement (P&L – pronounced “P and L”) may be required if the prevoius year’s tax returns have not been filed. A year-to-date P&L may also be required after Q1 of a calendar year.
Unfortunately, a P&L will only lower the qualifying income. The income from a P&L will only be used if it’s the worst-case scenario. If the income on the P&L is lower than previous years, then that lower amount becomes the qualifying income.
The P&L income will NOT be considered if it’s higher than the previous year’s income. The P&L is used to validate the income trend.
As always, we highly recommend calling us and letting us help determine the qualifying income. We’re here to help.
Loan Officer, NMLS # 729612