When January rolls around we often see encouraging messages, stories, tweets, or other social media posts encouraging us as we cross into the new year. A common word I hear used is “Perspective”. Perspective is an interesting word, Webster’s Dictionary gives it a few different examples to explain it’s meaning. One of the meanings it offers is “Point of View”, by stepping back and changing our point of view it can help answer questions or understand a subject better.
Getting the correct perspective on a borrower’s income can get challenging as we cross into the new year. I find paychecks that were issued before early February can result in the year to date (YTD) calculations getting all jumbled up and show CRAZY high amounts of income per month.
To understand this we need to get some perspective and look at the point of view of the IncomeXpert year-to-date income calculation.
For example, I have seen people who make $2,500 bi-weekly show an income of $15,000 per month due to the year to date calculation confusion.. Over the years I have learned to ignore this quirk in the way mortgage income calculations work, it is just one of those problems that can not be avoided, but really has no effect on the underwriting on the loan.
Let me provide a more detailed math example of what I mean…
The borrower earns $25.00 per hour and the payday frequency is bi-weekly with paystub dated Jan 14 2022 and pay period end date of Jan 07 2022. On this paycheck the borrower has worked 40 hours during the pay period of Dec 27th 2021 up to Jan 2nd 2022, and worked 40 hours Jan 3rd 2022 up to Jan 9th 2022. After reviewing the income documentation the YTD pay shows the borrower earned $25 x 80 hours = $2,000 gross income “for the year” (meaning 2022)
What we know following normal underwriting math
Based on the borrower working full time at $25 per hour the borrower should earn $4,333.33 per month ($25 x 40hrs x 52 weeks / 12 months). But when we do our YTD calculations (and underwriters always should be checking this to confirm steady income) When you underwrite the income on a loan the standard way we get the denominator to determine “ YTD Average” pay is to follow this formula.
Step 1 – Divide the pay period end date (in this case Jan 7th) by the total number of days in the month (31 in January). 7 divided by 31 gives us 0.23 of a month for our denominator. Said another way Jan 1st to Jan 7th is 23%of the full month.
Step 2 – Count the number of full months that have passed , for January that would be 0 since January is the first month and it has not fully passed.
Step 3 – Add the partial months denominator or full elapsed months in our example that would be 0.23 months.
Step 4 – Take the YTD amount total $2,000 / 0.23 months = $8,695.65 per month
Wait…what??? $8,695.65 per month?? We know that is not correct! This is where we have to get PERSPECTIVE on why this number is a mess…and why it really does not matter!
What is the proper perspective?
This systematic error is actually always in the YTD number but becomes less and less noticeable the later in the year we get. It is caused because most everyone who gets paid weekly or bi weekly has days you worked (and earned income) “roll into” the next calendar year. Because underwriting uses January 1st as the start date for all of our year to date calculations causes this minor blip in calculations. There is no need to correct it as it happens year after year… if you think about it the previous years W-2 might all have a little carry over income in them.
Why this really does not matter
When working out a YTD average the underwriter should NOT be calculated looking at a period of time under one year MUCH LESS under one month. I recommend between 18-24 months to get an average with a minimum of one year. If you use a denominator less than one year my opinion is the agency audit will fail since the time period is too short.
Average the year to date (e.g. 2022) + most recent year income (e.g. 2021) + previous year income (e.g. 2020) which means the income will be just over two years. I would use this method until roughly July of the current year. From July forward I would use 2021 + 2022 YTD only, that gives a very stable number. Using 2022 YTD only anytime in 2022 is not acceptable but using 2020 + 2021 + 2022 YTD after July 2022 is probably over analyzing things (30 months total).
The second option is a shorter time frame, 1 year bare minimum is acceptable on loans with strong other compensating factors, BUT use this method with extreme caution. Average the year to date (2022) + most recent year income (2021) which means your income will be the minimum of “just over” one year.
Again the longer the time period you average over, the better an average will be. Many jobs have high’s and lows in their income. Think of the mortgage business, would it be fair to say you earn the same amount of money per month in June as you do in January? NO, you would want to see two full years to see what an income trend is to make sure you have a TRUE average!
Last tip. Keep in mind when you are working on a borrower’s base pay and they work steady hours, you ONLY use the averaging method to confirm they are in fact working a steady amount of time. BUT for any other variable income (Variable base hours, overtime, bonus, commission, tips, etc) learning how to properly average becomes more vital!
Happy New Year, and I look forward to sharing more underwriting Point of View blogs as we roll through 2022~