How to Determine Variable Income for My Borrower

Variable income is the leading cause of income calculation issues for most lenders.  Variable income is generally categorized into the following classes as outlined in the guidelines: overtime, bonus, commission, tips, and base pay when the base is variable.

Variability in base pay typically occurs when it depends on hours worked each week, the amount paid per hour, or a combination of both. Accurately underwriting variable income requires adhering to the four fundamental requirements for all income categories.

Things to consider for variable income

The most common problem among underwriting teams is failing to analyze the income with enough diligence to meet the written guidelines. The agencies’ income trending rules clearly specify the timeframes—or diligence —needed to confirm income stability.

The second most common issue is the unclear wording in guidelines regarding documentation requirements for variable income. For instance, one agency may state that you need either a Verification of Employment (VOE) or the most recent pay stub and IRS W-2 forms covering the past two years. In 99% of cases, pay stubs alone won’t provide sufficient information to accurately determine income. This is because W-2 forms typically show only the taxable amount of income, without breaking it down into income types or verifying the minimum required timeframe.

Steps to Determine Variable Pay

1. Gather the Right Documentation
   Start by collecting:
   • Year-to-date (YTD) pay stubs OR;
   • Year-end pay stubs (YEPs) OR;
   • A Verification of Income (VOI) or Verification of Employment (VOE) from the employer or a third-party vendor
     
     
2. Set Up Your Calculation Tool
   Use a tool to calculate the income and ensure the timeframes are accurate. Most borrowers will require an analysis of YTD income, the most recent year, and the previous year. Some cases may only require YTD income and the most recent year. Note: Borrowers with less than 12 months of variable income history cannot qualify.
   
   
3. Classify Income Types
   Break down each type of income into its appropriate category. Ensure all income classes meet the four fundamental income requirements.
   
   
4. Perform an Income Trending Analysis
   Analyze income trends to determine whether it is acceptable. Income trends fall into three categories:
   • Stable or increasing
   • Previously declining but now increasing
   • Declining, provided the underwriter can demonstrate, with proper documentation, that the decline is unlikely to continue and that the borrower can meet future mortgage payments.
     
     
5. Calculate Final Qualified Income
   After determining the income trend for each class, perform the calculations required by the guidelines to establish the final “qualified income.”

Summary

The primary requirement from the agencies is for underwriting teams to ensure the qualified income used for a borrower meets the lender’s stability requirements. By following the steps outlined above, you can perform sufficient diligence to meet these requirements, ensuring income stability is clearly documented and compliant.

Guideline References
Fannie Mae   B3-3.1-03, Base Pay (Salary or Hourly), Bonus, and Overtime Income
Freddie Mac  5301.1  Employed Income