New Rules of Mortgage Lending: Income (2 of 5)

In this video, we’ll talk about what is for most people the biggest change when it comes to the new rules of mortgage lending after the mortgage meltdown — and that is the requirement to provide proof of your income.  So what counts as proof of your income? How is it different if you’re self-employed? And how much income does it take to qualify for the loan or home you want? Those are some of the questions I’ll answer in this screen cast…let’s take a look.

As we saw in the first video of this series, it’s easier to understand how to qualify for a mortgage today when we use the simple analogy of a chair. Like a chair with four legs, loan approvals are based on four distinct and essential requirements: Income, Credit, Savings and Equity.

Now out of these 4 legs, can you guess which one tends to cause more challenges than the others?

If you guessed Income, you’re right. Of all the rule changes, the way lender’s handle income today is dramatically different. So let’s dig a little deeper on the first leg of the chair and I’ll show you why it’s different and how to prepare…
With a few very rare and expensive exceptions, if you want to get a mortgage today, you will need to provide proof of your income. Lenders want proof of your income to make sure that your income is stable and it is likely to continue. They also want proof of your income to see how much you make. The lender wants to make sure that you will not be overly burdened by monthly payments that are too large compared to your available income.
So the second aspect of the income rule is that your income must be sufficient. It’s not enough to just prove that you have regular income. By proving your income you disclose how much you make, and the lender needs to see that you make enough to handle the payments on the size of loan you want.
Now at this point, you might be thinking “So what Dave? What’s new about that? Hasn’t everybody always had to prove their income to get a mortgage?” Well, you should know that in the years leading up to the mortgage meltdown, many people became accustomed to getting mortgage loan approvals without documenting their income. In California, especially in the higher priced areas, it is estimated that between 40 and 50% of home loans were made without documenting the borrower’s income in the same way as is required today

Before the financial crisis, when easy credit conditions were the norm, the mortgage industry found ways to relax the traditional requirement to document your income. But today, it is definitely game over for loan approvals based techniques that no longer exist, such as “Stated Income” “No Documentation” “No Ratio” or “Easy Qualifier.”
Maybe you are among those who always provided proof of your income, and in that case this particular rule may not affect you so much. But many people have loans today that were made during the period of easy credit and qualification did not require proof of income. If you are in this group, you really need to get prepared to document your income so that you are ready to buy your next home or so that you can take advantage of today’s very low interest rates and save a lot of money by refinancing.

Let’s talk about how you document your income. If you are salaried it is very basic, you need to provide copies of your pay stubs for the most recent 30 day period and also you need to provide copies of your W2 form for the last two years. The W2 form is sent to you by your employer in January each year and summarizes your total earnings for year as well a deductions that were taken for taxes.

If you are self-employed, or if you have supplemental self-employment income, you will need to provide complete copies of your most recent federal taxes returns with all schedules and attachments. When providing copies of your tax returns, you do not need to include your state tax returns.

If you have any other non-salaried income, for example rental income, dividends and interest, or royalties, you will also need to provide your most recent federal tax returns.

If you own a 25% or greater interest in a partnership, LLC or corporation, you will also need to provide the 2 most recent federal tax returns for that Partnership, Limited Liability Company or Corporation.

Finally, if you receive a Pension, or Annuity income or social security benefits, you should be ready to provide a copy of your annual award letter for each.

So now we’ve covered how to document your income, but as we saw earlier, the other aspect to this rule is that your income needs to be sufficient.

So how much income does it take to qualify for a mortgage? As a basic guideline, your housing expense should not be more than about one-third of your income before taxes. The precise requirement or tolerance will vary somewhat depending on the specific loan type being considered. In nearly every case, your housing expense combined with your other credit payments like car loans and credit cards must be less than 45% of your gross income. So a housing expense that is about one-third or less of your gross income is a good target. Now “housing expense” means more than just the mortgage payment. It also includes your property taxes, homeowner’s insurance and homeowner association dues (if any) on a monthly basis.

Let’s take a look at an example that will make this concept a little more concrete. Suppose a couple earns a combined income of $120,000 per year. So divided by 12 months in the year, their monthly pre-tax income is $10,000. They want to refinance a $500,000 mortgage and the new interest rate will be 4.875%. Their property taxes are $7,500 per year and their homeowner’s insurance is $1,500 per year.

So here is what these number look like on a monthly basis. The payment on just the mortgage is $2,646. Property taxes on a monthly basis are $625 and the insurance is $125. We’ll assume there are no HOA dues because this is not a condominium and the home is not in a planned community. The total of these figures is the monthly housing expense for this couple, which is $3,396.

The next step is to compare how the housing expense compares to the couples’ gross monthly income. So we simply divide the housing expense by the gross income figure and we get about 34% or roughly one-third. This is a balanced scenario and an approvable loan assuming the other legs of the chair check out, and we’ll get to those. But this is the basic formula that any mortgage lender will use to evaluate the first leg of our chair analogy. In practice, lenders also consider your non-housing debts too… like car loans and credit card payments, but for simplicity’s sake we’ll stay focused on the housing expense.

Now let’s change the facts of our example a bit and consider the same couple and the same loan application but let’s reduce their income to $6,000 per month. Maybe the husband lost his salaried job or maybe they are self-employed and business is down. It could be a number of things, but the point is that their current documented income is $6,000 per month and not $10,000. How does this change the picture? Well, $3,396 divided by $6,000 is more than 56% and that is too high. The housing expense would be too high a burden based on this couple’s monthly income under the new rules of real estate lending and this application would be denied I’m afraid. In order to satisfy the income leg of our chair analogy, you need to document your income and your housing expense needs to be proportionate to your income….about one-third or less is a good rule of thumb.

Let’s cover some basic tips on the topic of income qualification. Sometimes people have gaps in their recent employment history….this is time when they were between jobs. Generally, employment gaps in the same field or line of work can be explained and overcome. The lender will use your current salary to determine whether your housing expense is in balance even though due to the gap, your actual income for the year will be less.
For people who are self-employed, it is important to know that lenders will average your net income of the previous two years. They will not simply look at your most recent tax return or year-to-date performance. So this can either work for you or against you depending on the recent trend in your business.
Newly self-employed need to establish two-year history before income will be recognized. This is because lenders need to see a history of consistent income. So if you are currently salaried and thinking about striking out on your own as an independent, then you should definitely get your home refinance done first.
Finally, if you have any non-salaried income, get prepared to provide your tax returns. If you are self-employed and you don’t have a CPA or other professional tax preparer, you might seriously consider getting one. Accurate and timely filed income tax returns now matter more than ever.

So that covers the new rule about income when applying for a home loan today. You need to document your income and the income that your document needs to be enough to handle the payment on the loan that you want.

In the next video we’ll move to the next leg of the chair and we’ll cover just the key things you need to know about credit under the new rules of mortgage lending.

So that when you’re ready to buy your next home or take advantage of todays incredibly low interest rates by refinancing, you can feel well prepared and confident when you apply for your home loan.

Thanks for watching! Please feel free to leave a comment about what you learned.  Or maybe you have a question about something I didn’t cover.  I’d like to know what it is so please post your comment or question below. In the next video, we’ll focus on credit and I’ll share with you a surprising fact about credit scoring that most people don’t know. So please click the link for Video #3 and I’ll see you there!

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