Qualification Repair: Meeting the Income Requirement

October 14, 2011, Revised January 12, 2012

Borrowers without the income required to qualify for the mortgage they need have many possible options. “Income adequacy” is governed by general guidelines that can be adjusted to meet individual circumstances. It is “softer” than the down payment requirement. Income adequacy is always measured relative to the borrower’s payment obligations.

Maximum Debt-to-Income Ratio

The measure used most often to measure income adequacy is the ratio of the monthly payment on the new mortgage, property taxes, home-owners insurance, and other debt payments divided by income. The maximum ranges from 40% to 43%, but underwriters have discretion to accept higher requirements if they believe that circumstances justify them.

Debt payments are those that extend beyond the next 6 months and are not deferred for a year or longer. This includes HELOCs and other revolving credits, credit card debt that you don’t pay off at month-end, student loans, and alimony and child support payments.

Repairing Inadequate Income

The obvious way to repair inadequate income is to earn more, but there are also ways to make your existing income count for more. One way is to convince the underwriter that you can safely devote a larger proportion of your income to housing expense than is typical for someone in your income bracket. The best (perhaps the only) way to do that is to document that you have done it in the past – either as a past homeowner or as a renter.

Another repair could be to induce the underwriter to count income that would ordinarily be disregarded because of a presumption that it won’t continue. You rebut that presumption by presenting evidence to the contrary. Such evidence could be historical data showing that the income has in fact been generated over a considerable period. Or the evidence could be forward-looking testimony by someone in position to have knowledge of your prospects, such as your employer.

Income Used to Qualify

In general, only income that can be documented, and that can reasonably be expected to continue, is included in the calculation of the debt-to-income ratio. Documentation is the major challenge.

Wage and Salary Income: You must present W2s for the last 2 years, and paystubs covering the last 30 days. In addition, if your income has recently increased or decreased, you need a written statement from your employer (“Verification of Employment”) explaining the reason for the change and whether it is likely to continue.

Overtime, Commission, Bonus and Part-time Income: If you want overtime, commission bonus and/or part-time income to be counted, you must document that you have received it for 2 years, along with the W-2s and paystubs. In addition, you need a statement from your employer that it probably will continue.

Seasonal Income: The rules are the same for a seasonal worker, whose monthly income will be one-twelfth the amount earned during the working season.

Military Income:
Documentation rules are the same but if you claim pay above base pay for your rank (jump, hazard, special assignment, etc) you must provide an explanation of why it will continue. The same holds for housing, base and food allowances which can be included in your income if you can prove that they will continue. One-twelfth of your clothing allowance can also be included.

If you are deployed, you must explain in writing that your paystubs do not match your W2’s because you have been deployed to a War Zone and that your income is not taxed.
Business Income Including 1099 Income: You must disclose the last 2 years of tax returns. The income used will be an average of the 2 years, but subject to the various adjustments noted below. You also must report a profit and loss statement for the current year to date to show that your business is still profitable.

The income shown on your tax returns is net of any losses on schedule “C” or from K-1’s, while any income that is viewed as a one-time occurrence will be deducted. If you file a schedule “C” you may add any deprecation from that form to your income for the year.
If you have K-1’s you will need to include all pages and any supporting documentation. If you are self-employed, you must include your paychecks and W2’s in your documentation.
If there is a large difference between the incomes reported in the 2 years, you will need to provide written statements to support the argument for using the larger of the two figures.

Investment Income:
Ordinarily, the only investment income that is usable in qualifying for a mortgage is interest and dividends, and these may be discounted, depending on the source. Realized capital gains are viewed as too volatile to rely on. Funds obtained from liquidation of assets don’t count either because it is assumed that they will run out.

Income is always carefully reviewed by an underwriter, and if you have income of an unusual nature that you believe to be dependable, put your reasons in writing. Document whatever may be questioned.

Using the Income of Others

Co-Signers: A co-signer assumes responsibility for payment of a debt in the event that the borrower doesn’t pay. On FHA loans, 100% of a co-signer’s income can be used to raise the qualifying loan amount, up to the FHA loan limit. However, the co-signer’s debt is added to the borrower’s debt in determining the qualifying loan amount. This means that if the co-signer’s debt is large, his inclusion could add little or nothing to the qualifying loan amount.

Most conventional (non-FHA non-VA) loan programs don’t allow non-occupant co-signers at all. Those that do typically limit the incremental income to 50% of the co-signer's income, but they include 100% of the co-signer’s debt. As a result, there aren’t many co-signers on conventional loans.

Non-Occupant Co-Borrowers:
FHA allows a borrower to include the income of non-occupant co-borrowers who are close family members or can demonstrate a long-standing relationship with the primary borrower. That means that parents who want to help their children become homeowners can do it by becoming co-owners and co-borrowers. The loan amount must fall within FHA limits for the specific area, and the parents must meet the same underwriting requirements as the primary borrower.

Participating Investors:
Non-occupant co-borrowers are not allowed on conventional loans, but willing parents can become participating investors in a purchase classified as an investment rather than for occupancy. From the standpoint of the parents, being participating investors is the same as being non-occupant co-borrowers, since in both cases they are part owners, liable for the debt, and they must meet the same underwriting requirements as the primary borrower.

In most cases, mortgages on investment properties require 20% down, and are priced .75% to 1% higher than comparable loans to permanent occupants.

After purchase, the borrowers should ask the closing agent to record that one of the borrowers will in fact be occupying the house as owner and will be taking the interest deduction on his tax returns. It is also important that the occupant borrower make the mortgage payments in a way they can document later and have all utilities in their name. This will make it possible for them to refinance without the participating investors if their financial status improves in the future.

Reducing Debt Payments

If the debt-to-income ratio is swollen by large monthly debt payments, there may be ways to reduce the ratio by reducing the payments. Excess cash used to pay down debt will reduce debt payments. One possible option for borrowers who don’t have excess cash but do have a 401K is to borrow against it and use the proceeds to pay down other debt. Loans from 401K are not included in the debt ratio.

There may also be opportunities to reduce debt payments by extending maturities. This might be done by shifting balances from short-maturity debts to long-maturity debts, including new debts taken just for that purpose. A caution is that longer-maturity debts are likely to have higher interest rates, which make this a costly way to qualify.

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