If some of you have been following my blogs you know that outside of my “underwriting world” I am a new private pilot here in Michigan. One of the terms I have learned between my private pilot rating and my instrument training is when you get really close to a VOR (a ground navigation beacon) your instrument that detects the VOR’s location goes “crazy”. When that happens, you know you are above the VOR on the ground. So, the lesson here is you may be confused on the reading, but not confused about your location.
I find that a similar thing happens in the first few weeks of the year when looking at income calculations. The issue I am talking about is the year to date (YTD) calculations get all jumbled up and show CRAZY high amounts of income per month. For example, I have seen people who make $5,000 month look like they earn $32,000 per month due to the year to date calculation. Over the years I have learned to ignore it because I know what the borrower makes (which is lower). This, my friend, is “The Income Zone Of Confusion”.
When does the zone of confusion happen?
When you are evaluating any paystub with a pay period ending in January it is at its worst. The further into the year the less the error gets, but it is noticeable in February as well (but not to the extent of January).
What is the zone of confusion?
During the month of January for any employed borrower since a full month has not elapsed on the pay period end dates, YTD calculations become incredibly skewed. This error is found on employees that have “lag” time between working and payday. In other words, if the borrowers time card records hours for 7 or 14 days, but paid for that time one or two Fridays in the future.
$25.00 per hour is earned by the borrower
Work Period is Dec 24th, 2018- Jan 4, 2019
Pay Check Date Jab 11th 2019
$2,000 gross earning YTD as of pay period ending Jan 4th.
$25 x 2080 hours (assuming full time) = $52,000 / 12 months = $4,333.33 actual income
Year To Date Calculation
$2,000 earned as of pay period ending 01/04/2019. 4 days elapsed / 31 days in January = .13 months
$2,000 / .13 months YTD elapsed = $15,384.62 Per Month Earnings
WHAT??? The borrower does NOT earn $15,384.62 per month! What is wrong here??
How to overcome the zone of confusion.
Keep in mind that using a year to date method of income calculation is used to determine the actual income only on a person that does not have a steady rate of pay (IE $25 per hour 40 hours per week). The other reason we use YTD calculations is to “confirm” that a borrower with a steady paycheck does not have “gaps” in income that need explanation. For example, if I see your salary is $1,000 per month and your June 30th paystub says YTD income $4,500 something is wrong and needs to be addressed.
The way to overcome it is NOT to choose to do a “year to date” calculations that are based on anything less than 1 month. If you NEED to use an “average” method of income instead of a “calculating” method of income, you should use a 2 year + YTD average or a minimum of 1 year + YTD average
$25.00 per hour earned
$52,000 was last paystub YTD total for base income on the 12/21/2018 Pay Period End Date
$2,000 is the YTD total on the 01/04/2019 Pay Period End Date
$52,000 YTD 2018 + $2,000 YTD 2019 = $54,000 total income for period evaluated
$54,000 total income / (12 Months 2018 + .13 Months 2019) = $4,451.78 per month AVERAGE
As you can see the $4,451.78 “Average” is much closer to the real income of $4,333.33 then the “Zone of Confusion” determined the income of $15,384.62
Bottom line… there are just some errors in the methods we use to calculate income that we can’t avoid. The methods accepted and have been used for years in underwriting just can’t account for the “rollover” of earning income in one year but being paid on it in the next year.
And before you pull out your calculator and try to “fix” this issue, don’t waste your time. Since the rollover happens year after year there is no need to correct it. The W-2’s are accurate and show what you have been PAID ON (not earned) in each year. In addition, you can not look at a W-2 determine WHEN the income was earned, you can only confirm when it was PAID.
Hopefully, this helps explain the “zone of confusion” in all January paystubs…. And you realize you are not lost in the math….just that our accepted method of “detection” has some errors that are not worth fixing since we can easily overcome them!