When it comes to mortgage qualification, understanding the concept of non-taxable income and the practice of grossing up becomes crucial. In this post, we will delve into the details of non-taxable income, explore why it is adjusted, and shed light on the guidelines surrounding this important aspect of mortgage qualification.
Non-Taxable Income and Its Significance
Non-taxable income refers to earnings that are exempt from income taxes. These can include various sources such as child support, alimony, social security income, VA benefits, interest income, 401K/pension income, or any other documented income that is deemed non-taxable. While this income is not subject to taxation, it plays a pivotal role in mortgage qualification for many borrowers.
Why We Gross Up Income
Mortgage qualification DTI ratios are based on gross income not take-home income. The common DTI limit for conforming loans is 45%, while the government can be 55% or higher in some instances. The reason we gross up income is to level the playing field for borrowers who don’t pay taxes on some of their income. Since ratios are based on gross pay, they have built in room to allow for things not considered in a mortgage DTI calculator such as taxes, insurance, food, daycare, etc. So when you think of the 45% of our gross income you can use to qualify, versus the 55% you can not use, the 55% includes about 25% for federal, state, and local taxes… which the non-taxable income will not pay, so this is how we correct it. As we know it is nice to get $100 tax free selling something at a garage sale rather than $100 added to our paychecks which will not net us $100.
- $2,000 Employed
- $0 Gross Up
- $2,000 Total Income
- 45% DTI
- $900 Maximum Debt Amount
Non Taxable Income
- $2,000 Social Security Retirement
- $500 Gross Up (25%)
- $2,500 Total Income
- 45% DTI
- $1,125 Maximum Debt Amount
Understanding the Agency Guidelines
To determine the amount by which non-taxable income should be grossed up, specific guidelines are in place. Different agencies have their own set of guidelines. Let’s take a look at a few examples:
- 25% Fannie Mae: Reference B3-3.1-01
- 25% Freddie Mac: Reference 5305.2
- 3.75% Freddie Mac: Reference 5305.2 ** See Note **
- 15% FHA Reference: 4000.1 II.A.4 (P)
- 25% VA Reference: VA Handbook Chapter 4 Section 9
- 25% USDA Reference: USDA HB-1 3555.1 Ch 9
** Note for Freddie Mac 3.75%: This formula is ONLY for income sourced from the Social Security Administration. Examples of social security income include retirement, disability, and survivor benefits. The guidelines show the following calculation, which is just the long way to get 3.75%
$1,000 Social Security Income
X 15% without needing additional documentation of tax free income
X 25% multiply by the gross up factor
+ Social Security Income
=$1,037.50 total income grossed up
OR you can take the SSI $1,000 x 1.0375% = $1,037.50 per month
Documentation and Continuity
To apply the grossing up adjustment, it is essential to provide evidence that the income is indeed non-taxable and will continue to be non-taxable in the foreseeable future. This documentation serves as proof for lenders and ensures compliance with the guidelines set by the respective agencies.
Wrapping It Up
Understanding non-taxable income and the concept of grossing up is crucial for mortgage qualification. By accounting for non-taxable income, lenders can accurately assess the borrower’s overall financial situation and make informed decisions.
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