CVS Training & Development – www.caryvalentine.com – 816-985-2437
Topic 6 - Income Underwriting
(LINK TO CVS HOME PAGE)
To continue with our study of underwriting borrower capacity to pay, we now seek to asses
the borrower's ability to make the payment based on income stability. When we are
analyzing income for a tolerable risk, we must be concerned about two primary issues in
regards to capacity to repay:
1.)
Does the borrower posses a current and previous pattern of income stability?
2.)
Is the borrower's income sufficient to support the proposed mortgage payment and
all other debt the borrower may have?
At the end of this chapter you will be able to:
- Identify documents required to verify types of income.
- Calculate monthly income.
As we have pointed out repeatedly in the previous topics, what we are told about a
borrower's capacity is a tool to get to the proper documentation of pertinent facts. Without
documentation, what we say, hear, or just know is worthless in getting a decent approval.
The source of income impacts the documentation required for verification (i.e., a borrower
that is currently employed may require a pay stub and W2, while another who receives
Social Security Income and may require copy of an award letter. However, regardless of the
source of income and type of documentation required - the intent of this information is the
same - to establish income stability and the likelihood that a similar pattern of income can
be reasonably expected in the future.
We will first examine some of the more common sources of income, the move on to explain
how the borrowers' monthly income is calculated for underwriting purposes. For starters
review the chart below which you may download in printable form for future reference:
(Printable Version Download)
Source of Income
Salaried/Hourly Income
Documentation Requirements
Obtain the following:
-Most recent pay stub showing year-to-date earnings (pay stub must
be dated within 30 days from date of application to be valid).
-W2's covering the most recent two tax years.
-Verbal verification of employment (verbal VOE).
Verbal Verification Process must:
1. Be completed within 30 Days of closing.
2. Independently obtain phone numbers & addresses of
borrowers' employers.
3. Document names & titles of persons who confirm
employment.
4. Document the date of the phone call & and source of phone
number.
5. Include the name and title of the processor/underwriter that
performed the verbal verification.
1
CVS Training & Development – www.caryvalentine.com – 816-985-2437
Note: If a pay stub becomes outdated, you may do best to get a
second one if another pay period transcends the time spent in loan
processing.
Self-Employment Income
-Individual federal income tax returns for the most recent two years.
-Obtain most recent two years of federal business tax returns only if
the following conditions are present:
1. Borrower owns 25% or more of the business, and
2. Business structure is a corporation, an 'S' corporation or
partnership.
Commission Income
-Most recent YTD pay stub covering past 30 days.
-W2's covering the most recent two tax years.
-Individual federal income tax returns for the most recent two years.
Income Per Job or Contract
Basis
-Individual federal income tax return for most recent two years and,
if applicable:
-Most recent YTD pay stub to document the most recent one full
month of earnings if provided by employer.
-W2's covering the most recent two tax years if provided by
employer.
Rental Income
-Individual federal income tax returns for the most recent two years
as evidence of the receipt of rental income.
Note: If the property is listed on "Schedule E" of the tax return,
provide a copy of the lease to verify rental income.
Alimony, Child Support or
Separate Maintenance
-Select pages from the applicable agreement supporting three years
of continuance from the closing date.
-Document proof of receipt for most recent 12 months from one of
the following:
1. Court payment record,
2. Cancelled checks, or
3. Bank statements showing the deposits.
'Other' Sources of Income (i.e.,
Retirement, Social Security,
etc..)
-Document the source of income, as applicable with:
1. Award letter
2. Pension statement
3. Two most recent bank statements
4. IRS 1099, etc., OR
-Provide complete individual federal income tax returns for the most
recent two years.
-YTD pay stub covering most recent 30 days, and
Employed by Property Seller,
Real Estate Broker or a Closely
Held Family Business
-W2's covering the most recent two tax years, and
IRS Form 4506 or 8821
-Have the borrowers sign IRS form 4506 or 8821 covering the most
recent two years at application and/or closing, and send to IRS.
-Individual federal income tax returns for the most recent two tax
years.
Note: Forms 4506 and 8821 permit the lender to obtain the
borrower's income tax return form direct from the IRS.
Employment Gaps
-Document employment gaps of more than 60 days with a letter of
explanation (LOX) from the borrowers.
2
CVS Training & Development – www.caryvalentine.com – 816-985-2437
Calculating Monthly Income
Because income can come from a number of different sources, with each source potentially
reporting income differently, it is important that you know how to calculate your borrowers'
gross monthly income accurately.
A rule of thumb when calculating income is: If the income fluctuates, it will usually be
averaged over the last two years to determine the gross monthly income figure that will be
used in qualifying. Look at list of different income types below and check those with the
greatest potential to fluctuate:
Self-Employed Income
Commission
Social Security Income
Bonus Income
Salaried Income
If you selected self-employed, commission and bonus incomes, you're right. Because these
types of income are less predictable than Salaried or Social Security income they require
special handling when underwritten for risk. This is how the practice of averaging over two
years comes into play because a history of prior success over multiple years is the best
indicator of what may occur in the coming multiple years.
The formula for averaging income might look like this:
Tax Year
Gross W2 Earnings
2004 Gross Earnings
$24,580
2005 Gross Earnings
$42,310
TOTALS
$66,890
2 year total divided by 24
months
$66,890 / 24 = $2,787.08 (qualifying monthly
income)
As stated earlier, self-employment income is somewhat, difficult to describe in this tutorial
format. Underwriting this type of income involves special rules of analyzing federal tax
returns and identifying the borrower's business structure for proper documentation of
income. One thing I can tell you for sure, is that W2's prepared by a self-employed
individual of wages paid to him/her self will not normally, fly in underwriting. Think about it,
if we were all allowed to make our own documents for qualifying whether they represent
legitimate pay or not, then why have any income documentation requirements at all? Again
remember, that any borrower who owns at least 25% of a business trigger's the need for
income tax returns and subsequently, requires special care in processing. If they have this
kind of interest and influence within the entity we are trying verify their income to be from,
the secondary mortgage market investor would be especially, vulnerable to fraud and our
job as always, is to prevent fraud.
This leads us to the fact that the self-employed or commissioned borrower may not like
averaging because it usually, means less qualifying income for them than more. If they just
3
CVS Training & Development – www.caryvalentine.com – 816-985-2437
came out of a GOOD year (when they are applying for a loan), then they may be mad
because we are bringing DOWN their qualifying income by averaging over a prior year with
poor earnings (OUCH!). Your only savior in this case may be a few itemized, income tax
return items known as "phantom deductions" like depreciation, depletion or other that can
be added back to the adjusted gross income figure. However, these 'add-backs' rarely
amount to much with the exception of higher-income borrower scenarios. In fact, the only
significant amounts of 'add-back' income are sourced from depreciation for which most
borrowers may include investment property listed in 'Schedule E' of the income tax return.
If you would like more help on qualifying an income-volatile borrower, please contact your
instructor at admin@caryvalentine.com for individual assistance.
Just one more morsel regarding the self-employed borrower....
Even though we don't have the time here to efficiently and thoroughly instruct you on
originating, processing and underwriting the self-employer borrower, please download the
.pdf Fannie Mae form file below and take a look at it before moving on to the next topic:
(Fannie Mae Cash-Flow Analysis Worksheet)
This form (affectionately, called Fannie Mae 1084) is a worksheet used to analyze of selfemployed, rental income, or otherwise branded, "volatile-income" borrower. As you analyze
the borrower's income tax return, you will add certain deductions BACK to the adjustedgross income for qualifying and may just find out, that you can get that self-employed
borrower with four GU-GU-GILLION deductions to document enough income for a Fannie
Mae loan approval anyway! Simply follow the instructions on the 1084 form and '+' or ' -'
income and/or deductions right back in or out of the gross figure to see if you can land
within the conforming qualifying parameters. This form is the best though, way too underused way of qualifying the income-volatile borrower effectively.
Salaried-Income Payroll Periods
Now let's turn our focus on the most common, salaried borrower. If a person receives a
fixed salary we might assume that it is easy to figure out for qualifying purposes but that
isn't necessarily, so. Salaried borrowers may receive payroll on various types of time
frequency such as, monthly, semi monthly, weekly or bi-weekly. You must seek to discern
how these differences in pay frequency can alter monthly qualifying income for
underwriting. Below are some of the most common pay frequencies and formulas for
arriving at the right qualifying amount:
Weekly
This would generally reflect the normal work week of 40 hours. You would take
the number of guaranteed hours per weeks times 52 weeks to get annual gross
income and divide the number by 12 months to get the monthly income figure
for qualifying. Note the formula below:
40 hours x hourly rate x 52 weeks
= monthly qualifying income
12 months
Bi-Weekly
Bi-weekly or every other week would generally reflect 75-80 hours. In this case,
4
CVS Training & Development – www.caryvalentine.com – 816-985-2437
you would take the base pay, if provided, times 26 pay periods (annual figure)
and divide the number by 12 months to get a monthly figure as shown below:
80 hours x hourly rate x 26 weeks
= monthly qualifying income
12 months
Semi-Monthly
Often times, processors, loan originators and even underwriters make the
mistake of confusing "bi-weekly" pay with "semi-monthly" pay. They are pretty
similar for obvious reasons but in the end, the semi-monthly system allows for
only 24 pay periods instead of 26. Note the difference between the two in the
formula below:
80 hours x hourly rate x 24 weeks
= monthly qualifying income
12 months
Monthly
Monthly pay periods will typically, not state hours on a pay stub. To underwrite a
monthly-paid borrower, look for a statement on the pay stub like "Pay Period
ending __________ (applicable date ) or under "current earnings" or "earnings
for period ending" or similar language that implies a monthly pay style. A
monthly payroll might break down like this:
160 hours x hourly rate
= monthly qualifying income
12 months
Multiple-Income Source Borrower
This is our own special term for a borrower who receives a combination of two or
more types of income for qualifying. If the borrower is using rental income and
salary income to qualify, you would simply need to calculate each of the different
income sources per formulas shown above and then combine the incomes on the
applicable lines of page two of the 1003.
If you recall, the 1003 or loan application has a space for 'salary', 'overtime',
'net-rental income' and other income on the second page that can be itemized
out for qualifying purposes. Make sure you separate the incomes per the 1003's
instructions or the underwriter wont have a clue what you trying to claim for
allowable qualifying income.
Analyzing the Income Documents
Now, look at the income documents and answer the questions below each of them to help
you get into the mindset of seeking the most important data for income qualifying:
5
CVS Training & Development – www.caryvalentine.com – 816-985-2437
Pay Stub Exercise
1.) What type of pay period is reflected on this pay stub?
2.) Based on information listed on this pay stub, what is the current gross amount being
paid to the employee?
3.) What is the 'year to date' earnings for this employee?
4. Does the pay stub indicate that the borrower is paid on an hourly-basis or in some other
fashion?
This is a tricky pay stub to underwrite but a good example of how to zero in on the most
relevant information. Again, we are seeking a gross income figure which we cannot confuse
with the net pay figure. It appears from reviewing the year to date earnings and
mathematically calculating that with the gross pay will lead us to believe that the borrower
is paid on a semi-monthly basis. If it was a bi-weekly pay schedule, we would arrive at a
figure based on 26 pay periods a year instead of 24. The pay stub in this case, specifically
states that the borrower is paid on a "contracted" basis which clarifies that hourly pay-rules
are not applicable here. Now give the W2 below a try:
6
CVS Training & Development – www.caryvalentine.com – 816-985-2437
W2 Exercise
1.) What are the wages, tips, other compensation for this employee?
2.) What would be the monthly qualifying income for the borrower issued this W2 by their
employer?
Again we present this exhibit to purposefully, confuse you a bit. You may be wondering
which income we are talking about. Is it, 'wages, tips, other compensation' or 'Medicare
wages and tips' that will be used to figure gross monthly income for qualifying? For our
purposes, we will differentiate the two income designations apart per the IRS interpretation
of their specific taxable or non-taxable use:
Wages, Tips, Other Compensation: This Box is numbered 1 on the Form W-2. This
amount includes total wages, tips and other compensation paid to the employee during the
calendar year based on dollars received from the first pay day in January to the last pay day
in December. In addition, any amounts received as fringe benefits -- for example, the value
of group-term life insurance plan coverage in excess of $50,000 -- are also added to the
wages in Box 1. However, salary reductions for health and dental insurance plan coverage,
flexible spending account for health, flexible spending account for dependent care benefits
up to $5000, and contributions to a retirement plan, will reduce the income reported in Box
1.
Medicare Wages (HI): This Box is numbered 5 on the Form W-2. The wages and tips
subject to Medicare tax are the same as those subject to Social Security tax (Box 3), except
that there is no income base limit for Medicare tax.
Are you more confused after reading that? Most people are in this context but you should
know the official difference when your asked which income will be used for qualifying. My
personal experience is that the underwriter will always take the smaller amount of the two
which will be the 'wages, tips and other compensation'. Underwriters are concerned about
audits of their work and most often seek the conservative routes on income capacity
underwriting to appease the powers that they answer to. Check with your underwriter,
underwriters or investor matrix to survey multiple industry responders to this question.
Most of them don't even know the difference in what the two boxes are meant to
communicate per the local, state and federal government for taxable income purposes but
now YOU do.
Calculating Debt-to-Income Ratio (DTI)
Debt-to-income ratio or 'DTI' is the percentage of a consumer's monthly gross income that
goes toward paying debts. It is usually expressed as two numbers. The first number, most
often known as the "front-end" ratio, indicates the percentage of income that goes toward
paying off a mortgage principal and interest, mortgage insurance, hazard insurance,
property taxes (PITI) and homeowner's association dues if applicable. The second number,
most often referred to as the "back-end" ratio, indicates the percentage of income that goes
toward paying all recurring debts, including those covered by the first number, and other
debts such as credit card payments, car loan payments, and child support payments.
Lenders in the past stuck to requirement of a debt-to-income ratio of 28/36 to qualify for a
conventional mortgage but these ratios are often exceeded in automated underwriting
scenarios. Federal Housing Administration (FHA) loan ratios have typically, stayed close to
29/41 . An example of calculating the front-end ratio, might be as follows:
7
CVS Training & Development – www.caryvalentine.com – 816-985-2437
We want to find out what percentage of a monthly gross income figure of $3,000 would be
necessary to cover a monthly, PITI payment of $800. Here's the formula for this calculation:
Borrower's Gross Monthly Income: $3,000
Proposed Monthly PITI:
$800.00
or..
$800 / $3,000 = .266_ or 26%
26% is considered the "front-end" DTI ratio for this borrower scenario on this property.
The "back-end" ratio is the percentage of gross monthly income used for the proposed PITI
payment added with all other monthly payments/liabilities: Try this formula for calculating
the back-end ratio:
Borrower's Gross Monthly Income:
Proposed Monthly PITI:
$3,000
$800.00
Total of Other Monthly
Payments:
$600.00
Total Proposed Monthly
Debt Load:
$1,400.00
or..
$1,400 / $3,000 = .466_ or 46%
So, 46% is your back-end ratio.
Front and back ratios are combined in to the final DTI Ratio calculation and are written like
this:
26%/46%
Why are these calculations soooo... important? Because lenders set maximum DTI ceilings
on the ratios they will accept to prove that enough income capacity exists to approve the
loan. In the past, conventional lenders stuck to 28/36 ratios on high LTV loans. Since the
revolution of automated underwriting systems, there has been less emphasis on set DTI
ratios however, they still exist. Because of DTI restrictions, many self-employed borrowers'
fail to qualify because they take too many deductions and reduce their taxable gross income
down. Other borrowers' simply maintain so much revolving and installment monthly debt
that they fail to qualify from having too high of a back-end DTI ratio.
Our DTI calculations in the example above would indicate that the applicant is within their
housing allowance but will have too much total monthly debt to qualify. By knowing this, we
would seek ways to reduce debt or advise buying less house to lower the back-end or total
debt ratio. In other words, the DTI calculation signals certain choices you'll make in
originating and processing the loan so you must consider it early on.
A number compensating factors can get you exceptions on higher-than expected, DTI ratios
which we will study more in the upcoming topic. The real benefit of knowing how to
calculate DTI is so you can make the best recommendation to the applicant about their
prospective loan terms early in the process. If their DTI ratios are excessive, you may need
8
CVS Training & Development – www.caryvalentine.com – 816-985-2437
to prepare them for a more liberal set of guidelines and programs that may not have the
attractive loan terms initially, hoped for.
Again, contact your instructor at: admin@caryvalentine.com for a personal tutorial
on underwriting the income-volatile and/or self-employed borrower if you would
like more details about this special type of underwriting scenario.
Do you have questions or comments about what you just read? Contact your
instructor at:
admin@caryvalentine.com
The "Back" button on your browser or the "FAST101" link at the top of the page
should return you to the prior page so you can continue to the next resource.
9