Prequalifying Your Income and Employment for a Mortgage Loan Approval

As mentioned, your mortgage loan prequalification actually revolves around prequalifying four elements:

• Property
• Assets
• Credit
• Income & Employment

This sub-section provides a quick overview of personal employment and income issues that are considered during the mortgage loan application and approval process.

Employment

Your verified income level provides a more objective measure of your ability to repay the loan.  Your employment history and type gauges the stability of your income, and its probability of continuing into the foreseeable future.

Employment stability requirements for conventional loans are two years of continuous employment, preferably in the same general field.  Exceptions to this two-year requirement are given for military service and academic studies.  A new job is acceptable if it is in the same field or related to the previous employment.

Of course, there are often gray areas when it comes to steady employment:

• Self-employment. Self-employed borrowers must show steady and profitable self-employment for five years.  This requirement can be lowered to three years if the borrower was previously in a related field.
• Part-time employment. Income from second and part-time jobs are acceptable for qualification purposes, as long as such employment has been ongoing for two years.  Exceptions to this two-year requirement may be given if the part-time job is related to the primary job or training.
• Seasonal employment. Seasonal jobs are acceptable as long as they have been regular for at least two years.

 

Regarding income, the borrower must document sufficient and acceptable income to qualify for the loan.  Sufficiency is discussed in the worksheet below.

Acceptability is rooted in the employment source and documentation of the income.  As long as the income is derived from an acceptable employment source and that income is documented and verified, then the income is normally acceptable.

When qualifying income, the lender seeks to calculate the gross monthly acceptable income.  Gross income is basically all of your acceptable earnings prior to paying any taxes or calculating deductions.

Lenders tend to lump acceptable income into five groups.  These groupings determine how the applicant’s qualifying income is calculated:

• Base income
• Overtime, bonuses and commissions
• Self-employment, dividends and interest income
• Rental income
• Other income

Base income

This is the starting point with most borrowers.  The base income is essentially the borrower’s consistent and relatively fixed monthly income.

• Salaried borrowers merely divide their gross annual income by 12 months.
• Hourly wage earners must calculate their gross income for 35-40 hours per week (as applicable) and multiply by 4.2 weeks (per month) to calculate the gross monthly income.  If you are paid every two weeks, multiply your biweekly gross earnings by 2.1 weeks (per month) to calculate your monthly payment.

Overtime, bonuses and commissions

Unstable income such as overtime, bonuses and commissions are averaged over the past 24 months or two years.  The monthly average is added to the base income.

For example, if Jane received commissions of $15,000 last year and $12,000 the previous year, then her monthly average over the past two years is $1,125 per month ($27,000 divided by 24 months).  This $1,125 calculation is then added to Jane’s other income to determine her qualifying income.

Self-employment, dividends and interest income

These are also considered unstable income and must be averaged over the past 24 months.  The monthly average is also added to the base income.

Rental income

Any income from rental property that the borrower will own at the time of closing can be counted as additional borrower income.  However, there are two ways to calculate the effect of rental income, depending on the type of property: owner-occupied or non-owner-occupied.

• Owner-occupied. If the borrower will be living in one of the units in the rental property, then 75% of the gross rental income is added to the borrower’s gross personal income for calculation.  For example, if the borrower is purchasing a three-flat and the two rental units will earn $500 each, the borrower will add $750 (75% of the $1,000 gross) of income for qualifying purposes.
• Non-owner-occupied. If the borrower will not be living in the subject rental property, it gets a little complicated.  The gross income is subtracted against the PITI payments for that property.  If there are profits, 75% of the net rental income is added to the borrower’s other qualifying income; the front-end DTI ratio is based on the borrower’s home and ignores this rental property.  If this property produces a loss, that monthly shortfall is treated as a long-term liability and held against the back-end DTI ratio.

For example, if the borrower owns a four-flat investment (non-owner occupied) property earning $2,000 per month and monthly payments of $1,400, the property’s NET rental income is $600.  This borrower would then add $450 (75% of NET) to the income calculation.

Other income

Other sources of income such as alimony, child support, judgment awards, trust grants, public assistance, welfare, etc., are acceptable as long as they are (1) documented, (2) stable and (3) will continue for at least three more years.

If the borrower receives alimony or child support, for example, that borrower can use that income for mortgage qualification—if the borrower can document consistent receipt of those funds.  Unfortunately, many divorced borrowers find that they have a difficult time documenting child support and alimony unless it is handled by the courts.

Income Qualification

There are two ways to qualify your income:

• The quick way: Affordability Table
• The detailed way.

For first-time homebuyers, we recommend that you begin with the quick way.  Just use our best mortgage lender directory to find a mortgage loan provider who can give you the information and quick preapproval you need.

For homebuyers who really want to know what goes into income qualification, the detailed method is discussed below.  It provides a thorough view of the steps mortgage lenders normally follow to qualify an applicant’s income.

The lender qualifies an applicant’s income by examining the ratio of all long-term monthly liabilities (including housing) and the gross monthly qualifying income (from acceptable sources).  Residential mortgage lenders deal with monthly debt and income amounts; and, again, gross income is pre-tax, pre-deduction income.

To begin, add together your acceptable and verifiable income from the preceding five groups (base, bonuses, dividends, rental, etc.) to determine your total qualifying income—your gross monthly income.  This figure is used with the projected monthly debts to determine your Debt-to-Income (DTI) ratios, which is then used for income qualification.

In the following worksheet, you will qualify your income by calculating your monthly housing payments and long-term liabilities, as well as gross monthly income.  You will then use these figures to determine the two debt-to-income (DTI) ratios that your lender will use to qualify your application.

The two DTI ratios are the Housing (or front-end) ratio and the Total Long-Term Debt (or back-end) ratio.  The conventional loan guideline calls for housing ratio to be no more than 33% of the gross income, and the total long-term debt ratio to be less than 38% of the gross income.  Of course, there are always exceptions and alternatives.

The Detailed Way to Qualify Your Income

All the calculations above are based on monthly figures. Now that you have some rough calculations, here’s what to consider:

• If your total long-term Debt-to-Income ratio is over the limit, you may have to pay off some of your credit card bills or again lower the loan amount.
• If your housing expense (front-end) ratio is over the 33% limit, then you may need to seek a lower loan amount or select a different loan program with lower qualifying rates.  Again, however, there are exceptions and options.  If you have strong compensating factors, you may be able to qualify with DTI ratios of 38% to 40%.

Both ratios begin with a calculation of the applicant’s gross monthly income—that’s the pre-tax and pre-deduction income.

The projected housing expense ratio is the projected monthly housing payment divided by the gross income.  Housing expense is essentially PITI, or principal, interest, taxes and insurance (along with any association dues).  Most lenders prefer that the front-end or housing expense ratio not exceed 33% of the applicant’s gross monthly income.

The total long-term debt ratio includes the projected housing payment and all long-term debts, divided by the gross income.  Long-term debts are any liabilities that will take 10 or more months to pay off—thus the housing expense is included.  With revolving debts, lenders will use the minimum required payment for its debt-to-income (DTI) calculation.

Some lenders allow you to ignore the payments for any revolving balances that will be paid off before the closing.  Most conforming loan programs require that total long-term debts should not exceed 38% of the applicant’s gross monthly income.