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How is income calculated for mortgages?

The process of analysis of a borrower’s income for mortgages is one of the best documented processes in the lending world. Regardless of the investor or agency that is offering the loan, an overwhelming majority of them follow these four principles to determine how income is calculated for mortgages.

Principle # 1: Income must reasonably continue for 36 months to qualify

Since mortgages are long-term loans and generally offered between fifteen to thirty years, the investors want to make sure that the borrower will reasonably expect to have the income to repay it for the foreseeable future.  Each agency (Fannie Mae, Freddie Mac, FHA, VA, and USDA) provides guidelines on how to determine if the income is reasonably expected to continue for 36 months.

Principle #2: Income must be stable to qualify

The word stable is defined as a longer term look at a borrower’s income.  While many borrowers have salaries or work a fixed number of hours at their employment, there are many more that do have variability.  The agencies generally want mortgage companies to look at a two-year history of these types of variable incomes. In their guidelines they want the lenders to confirm what the borrower earned in the current year, what the borrower earned in the most recent year, and what the borrower earned in the prior year.  The lender must then look for an income trend to confirm if the income is in fact stable.  Mortgage income is typically considered stable when the year to year percent change does not decline by more than 3 to 10 percent. Investors will have different risk tolerance on what they consider stable. Once the income is determined to be stable the lender can take an average of the two most recent years for the qualifying borrower income.  This type of evaluation takes the highs and lows of the income and produces a borrower’s calculated income that can be relied on to pay back the mortgage.

Principle #3: Income must have the proper history to qualify

Depending on the type of income that is being calculated for a mortgage, this history can vary between zero days or multiple years (normally two maximum).  For example, mortgage income that doesn’t require a history are things like social security. Once the government starts paying the borrowers retirement benefits they are considered to be permanent.  On the other hand when a borrower is using employment the lenders want to see a two year history of working to confirm that the borrower can hold a job and maintain a certain level of income that is then calculated for mortgages. 

Principle #4: Income must be documented to qualify

The major agencies (Fannie Mae, Freddie Mac, FHA, VA, and USDA) all require the borrower to document the income sources.  This documentation constitutes many types of documents all depending on the type of income for what is required.  Examples of proper documentation include items such as recent pay stubs and W-2’s for employed borrowers, two years tax returns with profit and loss statements for self employed borrowers, and award letters for social security income or pension for retired borrowers.

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