When reviewing a borrower’s paystubs, you’ll quickly notice that payroll providers often use different formats and terminology, making it challenging to accurately determine employment income. For example, something as simple as overtime might be labeled in a variety of ways, such as Overtime, OT, Double Time, Weekend OT, Triple Time, and more.

To address this issue, focus on placing each paystub entry into its proper class  of income, rather than getting caught up in the exact wording. As the saying goes, If it walks like a duck and quacks like a duck, it’s a duck! By grouping income accurately, you can determine whether it is stable, continuous, and has sufficient history to qualify.

Key Considerations

Industry guidelines define the major classes of income typically found on a paystub. These categories often come with specific rules, required documentation, and the minimum history necessary for qualification. Learning how to properly classify these income types is the essential first step in determining how they count toward a borrower’s qualifications.

If you incorrectly assign income to the wrong category when submitting to an Automated Underwriting System (AUS), it could negatively impact the approval outcome.

The primary categories of employed income in most guidelines include:

• Base Pay
• Overtime
• Bonus
• Commission
• Tips

Other types of income, such as shift differential, may still be usable but need to fit closely into one of these classifications. For example, shift differential may be treated as Base Pay for a consistent night-shift worker but might resemble a Bonus for someone who earns it sporadically.

How to Determine the Variable Pay of Employed Borrowers

1. Gather the Right Documentation

If you’re using a Verification of Income (VOI) or Verification of Employment (VOE) from the employer or a third-party vendor, this article may not fully apply. These documents generally classify income for you. 

If instead you’re working with the following, this guide is for you.

• The borrower’s most recent YTD paystub,
• Their last paystub from the prior year, and
• Their prior year’s tax documents,

2. Set Up Your Calculation Tool

Use a tool specifically designed to calculate income and ensure you’re applying the correct time periods. Most borrowers will require an analysis of:

• Year-to-Date (YTD) income,
• Most recent full year’s income, and
• Prior year’s income.

Generally, variable income cannot be used unless there’s at least 12 months of documented history.

3. Classify Income by Category

Assign each type of income to its appropriate category in your calculation tool. For instance:

• Base Pay may include vacation pay, holiday pay, and PTO.
• Do this for all income types that meet the documentation and time requirements.

4. Conduct an Income Trend Analysis

Evaluate whether the income trend is acceptable. Income trends typically fall into one of the following:

• Stable or Increasing: Ideal scenario.
• Previously Declining but Now Increasing: Acceptable with proper explanation.
• Declining: Use only if you can thoroughly document and demonstrate that the decline is not ongoing and will not impact the borrower’s ability to repay.

Note: you need to perform this trending on each class of income.  This includes base, overtime, bonus, commission, and tips.

5. Calculate Qualified Income

Select the appropriate average which matches the result of the trend analysis to determine the qualified income for each class. This will form the basis of your underwriting decision.

Summary

Many lenders make errors by failing to define income classifications and what fits into each category. The primary goal of income qualification is ensuring that the borrower’s qualified income meets the stability requirements of the lender or investor purchasing the loan.

According to industry audits, the Capacity section of underwriting remains the most error-prone part of the process. By properly analyzing and classifying income, you can save your company thousands of dollars in errors and post-closing issues.

Guidelines
Fannie Mae General Income Requirements   https://selling-guide.fanniemae.com/sel/b3-3.1-01/general-income-information

Freddie Mac Employed Income Requirements
https://guide.freddiemac.com/app/guide/section/5303.1