CHAPTER 3
Getting Your Finances Together
For purposes of getting a mortgage, your finances come in two forms: your income and your assets. Income is how much money you make, and assets are used for your down payment and closing costs. Now that you’ve gotten your approval, you’ll need to understand how your finances will be viewed and documented by your lender.
3.1 WHAT WILL THE LENDER LOOK FOR WHEN EXAMINING MY ASSETS?
First and foremost, you need to make sure the assets belong to you and you have access to them. Sometimes first-time home buyers share a savings or money market account with their parents. Even though your name might be on the statement, a lender might split that asset between you and your mom.
Let’s say you have a checking account with your mom that you used all through college, and now there’s about $12,000 in the account that you plan to use for a down payment. If your mom’s name is on the account, you may only get credit for $6,000. If this happens, have your mom turn over that account to you by writing a short gift letter stating, “I’m giving all these funds to my wonderful son so he can buy a house.” Any asset you list needs to be all yours.
Another consideration may be how “liquid” the asset is. If you have a retirement account worth $50,000 but can’t get to it unless you retire, it’s not liquid. At least to a point. You can cash in that retirement account or you can leave it alone and let the lender use a partial amount that can be included in your assets for purposes of getting financing. If you’re a first-time home buyer, there are provisions that allow you to withdraw funds from an IRA to be used to buy a home. A first-time home buyer is technically defined as not having owned a home in the previous three years.
Some accounts let you cash them in, but only under a penalty. If you can get that same $50,000 for the purpose of buying a home but there’s a 10 percent penalty, then the lender might also deduct that 10 percent, which leaves $45,000. Be careful that you understand the tax and penalty implications of tapping retirement accounts by speaking with a good tax accountant or financial planner.
If you don’t cash in the account, a lender can still use that asset to help qualify you for a home loan. In this case, the lender will typically use 70 percent of your vested balance to count toward your total assets. If you have $10,000 in a 401(k) or IRA, the lender will count 70 percent of that toward your asset requirement, or $7,000.
In addition to money used for down payments and for closing costs, there is one other asset requirement for most loans: reserves. Reserves are funds that must be present after you close on your purchase, and they are normally expressed as multiples of your new house payment. If your new mortgage payment, including taxes and insurance, is $2,000 and a loan requires two months of reserves, then the lender will verify that two months times $2,000, or $4,000, is present in reserves after all the dust has settled.
Even though you won’t have to “cash in” any of your retirement accounts and take any early withdrawal and tax penalties, retirement accounts can be used as reserve assets just by your having them.
3.1A WHAT IS A FINANCIAL GIFT AND WHAT DO I NEED TO DO?
A financial gift (congratulations, by the way) can come from an acceptable source, and the funds are not expected to be paid back. The acceptable source can be from a blood relative, a spouse, a domestic partner, a qualified non-profit or what Fannie Mae describes as someone with a “clearly defined and documented interest in the borrower.” But if you do expect a financial gift, you’ll need to follow certain guidelines to make sure the lender will count the funds being received. Your entire down payment, along with funds for closing costs, are allowed to be given to you without the need for you to provide documentation of a minimum contribution of your own funds. This is a recent change and the documentation requirements are much less stringent than they used to be.
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It used to be that unless the gift was for at least 20 percent of the down payment, the borrowers must be able to document at least 5 percent or $500 of their own funds in the transaction, depending upon the loan program. Today, there are no such minimums. And if the donor wires the gift funds directly to the settlement agent instead of to the borrowers, it will save a lot of paperwork and headache.
If the donor sends the funds directly to the buyer’s bank account, the lender will need to document the source of the deposit, which is standard practice for any loan. To avoid this paper trail of where the funds came from and where they went, the donor instead wires the funds to the settlement agent who then lists the financial gift on the final settlement statement.
Recall that the loan application (1003) asks for the source of funds for the transaction. In this case, simply reply, “Gift.” You’ll then need to document the relationship with the donor, which is easily done with an explanation letter. Your loan officer will walk you through this simple process.
3.2 HOW DO I DOCUMENT MY ASSETS?
To document your assets, the lender typically asks for the three most recent monthly statements or the most recent quarterly or annual statements. These documents will show a pattern of savings and help determine if the asset is viable, or the likelihood of that asset being available in the future to provide income.
Lenders like to see that you’ve saved up your money to buy a home and not borrowed it from anywhere else. Borrowing money from another source in order to buy a house could mean that someone else has a prior interest, called a lien, on the property you’re about to buy.
If you make $5,000 per month and your bank statement from last month shows a $30,000 deposit, you can bet the lender will want to know where that $30,000 came from before moving any further in approving your loan. Lenders use three months of statements to help verify there were no large deposits just before buying or, if there were deposits, to be able to explain where they came from. Three months of statements will show an average balance over an extended period and not just a snapshot with a dollar figure.
3.3 HOW DO I DOCUMENT MY INCOME?
That depends on how you’re employed and the nature of your job. How you’re employed and how you’re paid will in fact determine what kind of documentation your lender might ask for. It can also depend upon the degree of approval. This is why it’s important to get your approval in the very beginning of the process, so you’ll know exactly what you need to do to show income.
If your loan officer is asking you for two years’ worth of tax returns, your two most recent W-2s, and all of your bank and retirement savings, ask why all of that stuff is needed. Why go through all that work when you may not need all of it? But understand that this doesn’t mean you should do nothing at all before applying for a mortgage. On the contrary, you need to know what to expect to avoid any pitfalls along the way.
Documenting income simply means proving it, such as having it verified by a third party, like your boss. Begin to document your income when you begin thinking about buying a home.
3.4 IF I JUST GOT MY FIRST JOB, HOW CAN I PROVIDE A W-2 FROM LAST YEAR?
Most loan programs will require that you have been employed full-time for the previous two-year period. Why? One of the reasons is to establish a little stability. Yes, you got your first job working in the mall, but will you be doing that job two years from now? Lenders not only look at your current situation but try to predict what your future will look like. They can do that only by looking at your recent past. If you’ve been employed for less than two years, you may need to wait to get that loan.
That is, unless you’re fresh out of school or the armed services. Lenders understand that if you went to college and got your degree, then that shows a little stability; so instead of a two-year work history, you’ll need to provide only your transcript or degree, showing when you graduated and who your new employer is.
In the armed services? During peacetime, you have to wait to complete two years of service just as a civilian does. That two-year period gets reduced to as little as 90 days during a war. And if you are deployed somewhere, you’re instructed to assign someone a power of attorney to enter into contracts on your behalf. We’ll specifically discuss Veterans Administration (VA) loans in Chapter 7.
Do you have a “gap” in your employment history? If that gap is for more than 60 days, you’ll need to document the reason. It’s okay if you’ve been laid off; you just need to document that fact. Two years of employment means two years in the workforce.
3.5 WHAT DO YOU MEAN BY “HOW YOU’RE PAID”?
It means how much and how often you’re paid. The most common and simplest form of pay is a monthly salary. If you work for someone else, you get a pay stub each pay period. This pay period can vary; it can be weekly, every other week, twice a month, monthly, or whatever you and your employer agree upon. At the beginning of each calendar year, you will receive from your employer your W-2, which shows last year’s wages.
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When a lender asks you for last year’s W-2 and for your most recent pay stubs covering the previous thirty days, the first thing the lender will do is match them up to see if your year-to-date earnings are similar to what you made last year.
For example, if your W-2 shows you made $24,000 last year and your current monthly pay is $2,000, your earnings have just been verified. Your pay stub matches your W-2. Or, if you made $24,000 last year and you’re making $2,500 a month this year, it shows that you got a raise. Again, no problem.
Problems can occur when your W-2 indicates you made $24,000 last year, and six months into the new year you can only show $8,000 in income; this raises a red flag. According to your W-2 you made $2,000 per month last year, but your year-to-date pay stubs in June of this year show $8,000, or $1,333 per month. Either you got a pay cut, you were out of work for a period, or you had your hours reduced. That’s why your loan officer asks for both your W-2 and your most recent pay stub(s).
3.6 WHY DO LENDERS ASK FOR THE MOST RECENT 30-DAY PAY STUBS?
Lenders need to establish, again via third-party verification, your pay frequency. Your pay stub will show your regular earnings during a particular pay period. This is important to correctly calculate gross monthly pay. If you get paid on the fifteenth and thirtieth of the month, your gross regular wages will be the same every month. If you get paid $1,500 on each of those dates, your monthly income is $3,000. This gross pay is used to calculate your debt ratios.
When calculating income, a not-uncommon mistake loan officers make is that they don’t realize that some borrowers get paid every other week instead of twice per month. These borrowers will provide their two most recent pay stubs, yet it won’t reflect a full month’s pay. If you get paid every other week, don’t make this mistake; it might hurt your ability to borrow more money.
If you get paid every other week, here’s how to calculate your gross monthly income: Take your gross paycheck for one pay period, multiply that by twenty-six weeks (every other week of the year), then divide that amount by 12 (months). If your gross pay is $2,000 every other week, your gross monthly pay isn’t $4,000, it’s $2,000 × 26 ÷ 12, or $4,333. That’s why pay stubs covering the most recent 30-day period are needed—to check both gross pay as well as frequency.
3.7 IF I GET PAID IN CASH, HOW DO I DOCUMENT THAT?
There are two things a lender can do. One is to write a letter to your employer, verifying how much you make and how much you’ve been paid year to date. The other way is to match up what your application says with your W-2.
If you don’t get a W-2 or a pay stub and get paid in cash, you need to make certain that you don’t spend any of that money until you deposit it in the bank, establishing a record of regular pay of the same or similar amount. After that, you can pull your money out of an ATM machine. But remember, without pay stubs or W-2s, verifying cash payments is difficult.
3.8 HOW DO I CALCULATE HOURLY WAGES?
If you’re paid by the hour, the lender will simply look at your pay stub to see what you get paid each hour and multiply that by the number of hours worked. Remember, a lender wants to see full-time employment to calculate income. If you’re just working twenty hours per week, it may not be considered full-time employment, which typically means a minimum of thirty-six hours each week. Easy enough, right?
If you make $15 per hour, multiply that times the number of hours worked—say, 40 hours—to get your weekly pay. Multiply that weekly pay by 52 (weeks in the year) and then divide by 12:
$15 × 40 hours × 52 weeks ÷ 12 months = $2,600
3.9 HOW DO I CALCULATE OVERTIME?
You can include overtime wages in your income, but there are some important facts about overtime that you need to be aware of.
I remember a client who filled out a loan application with me and added his additional overtime income to the income he put on his loan application. His overtime had been rather significant recently: 20-plus hours each and every week for the previous four months. He had gotten some bad advice from someone who told him that by boosting his year-to-date income with extra overtime, he could qualify for a larger loan.
Bad news. A borrower must establish a two-year history of consistent part-time employment in order for those funds to be counted. Sure, there’s more money for down payment because of the increased overtime, but it doesn’t help to improve debt ratios. Why? Because if the borrower is counting on part-time work to pay the mortgage and then business slows down at the job, guess what? No more part-time work, only potential problems making a house payment.
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Overtime pay is verified by reviewing your pay stub showing year-to-date regular earnings and the additional space showing “overtime wages,” reviewing last year’s W-2, and obtaining written or verbal verification from your employer.
For instance, say you have worked overtime on your job for the past several years. In fact, one of the reasons that you took the job in the first place was that you could get overtime. You always got it, each month, every month. Your hourly wage is $20 an hour, you get paid time-and-a-half for anything above a standard 40-hour work-week, and you average ten extra hours per week. Without the overtime, your gross monthly income, for purposes of calculating ratios, would be $20 per hour times 40 hours, or $800 per week.
52 weeks × $800 = $41,600 per year
$41,600 ÷ 12 months = $3,466 per month
If you use a 28 front-end housing ratio, that’s 28 percent of $3,466, or $970. By subtracting $100 per month for property taxes and $50 per month for hazard insurance, you get $820 available for principal and interest payments. Based upon a 30-year fixed rate of 7 percent and a housing ratio of 28, your qualifying loan amount is around $123,000.
Now let’s run the same number with 10 additional hours of time-and-a-half pay. This adds another $300 per week in usable income, or $4,766 each month. Under the same scenario you now qualify for a loan amount closer to $170,000!
Your lender will then review your pay stubs to verify consistent regular and overtime earnings year to date. Your W-2 will also be matched up with your earnings. These numbers won’t match up exactly, but they must be similar and regular. If your overtime is spotty and hard to match up, it’s likely your lender can’t count it.
Your lender will take considerable effort to verify your overtime pay history. This information will also be verified when W-2s from the previous two years are compared with your year-to-date pay stub. Your lender may also write your current employer asking not only how much you were paid over the last two years, but also if there is a likelihood that overtime will continue in the future. Anticipating having overtime wages to pay the bills and then having your hours cut back is no happy feeling.
3.10 HOW ARE BONUSES USED TO FIGURE MY INCOME?
Bonus income is typically averaged over the most recent two-year period, with any year-to-date bonus money added in. Bonus income can vary from person to person, but lenders will take into account whether you have a history of bonus payments and how regular and frequent your payments have been.
Some loan programs try to determine whether the bonus income can be used for debt service. Debt service is a fancy way of saying “using the money to pay the bills.” This means determining whether you will have bonus money available to you to pay your regular bills every month.
Do you get your bonus once per year or more frequently? If you get an annual bonus, your lender might want to determine whether you use that money to pay bills throughout the year—after all, you’re using this income to calculate debt ratios—or whether you will use your bonus to fly to Tahiti.
Annual bonus money is sometimes more difficult to use in a debt ratio than monthly or even quarterly bonus money. Bonus money earned every month or every 90 days can conceivably be viewed as being available to pay regular bills, month in and month out.
The other consideration will be the history of your bonus payments. Just as with overtime pay, lenders might ask for verification of bonus money paid to you, and how much and how often payments were made.
If you get an occasional bonus every few months and nothing in between, don’t expect those bonus funds to be used to calculate debt ratios. Instead, the lender will just count your regular wages and use the bonus income as nothing more than something nice to have. Don’t plan on being able to count bonus income unless you have a history of receiving bonus checks in similar amounts, on a regular basis, with a likelihood of continuance.
3.11 HOW DO I FIGURE MY INCOME IF IT IS BASED SOLELY ON COMMISSIONS?
Carefully. If you thought lenders scrutinized your bonus income, they’ll research your employment history even more than normal if you work on straight commission. They’ll also examine your income tax returns to see if you have additional business expenses. Commissioned income is typically a percentage of gross sales paid to the salesperson. If sales are fantastic one month, you’re a millionaire. If they’re flat the next month, you’re waiting for the month that follows. Commissioned folk have all heard the expression “fried chicken one month, feathers the next,” meaning, of course, that one month you’re living large but the next month you’re living not so large.
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Commissioned income can fluctuate. One reason may be the type of product you’re selling. If you get commission on back-to-school supplies, you may have a huge August and September, but your November numbers won’t be as strong. Are you a real estate agent? All things being equal, spring and summer show more home sales than fall or winter. Ski boats? Bathing suits? You get the picture.
Commissioned income can be seasonal. If you have seasonal commissioned income, your lender will typically use your income from the previous two years, as verified by your income tax returns and W-2 statements, along with your year-to-date pay stubs, and then take a monthly average to calculate monthly income.
For instance, two years ago you made $55,000; last year you made $62,000; and six months into the current year you made $40,000. How do you calculate your gross monthly income? Add $55,000, $62,000, and $40,000 to get $157,000, then divide by the number of months it took to make that, which is 30 months. Divide $157,000 by 30 and you get $5,233 per month. This is the amount your lender will use to calculate your ratios.
People who earn seasonal commissioned income are at a slight disadvantage when compared to those who earn nonseasonal commissions. Seasonal commissions need to be stretched over a longer period than monthly income. Why? If seasonal commissions come in big chunks, the borrower needs to manage that money better than someone who gets paid a similar amount every month. No “paycheck to paycheck” living here. The big check needs to go into the bank and be saved to pay future bills until the next big commission arrives.
If you haven’t figured this out already, I’ll lay it out for you. Are you expecting a big bonus or commission check in the near future? Did you just land a big sale but won’t get paid on it for a couple of months? If this is the case, then wait to apply for your mortgage loan until your big commission is actually paid to you. A large increase in income will help your monthly average considerably. If you can wait, do so.
For nonseasonal jobs such as insurance, telephone sales, or advertising—jobs that pay a commission based upon regular sales of a product or service—lenders have an easier time averaging such income because the amounts are similar and come regularly. But note that lenders don’t have a formal classification of “seasonal” and “nonseasonal” jobs. For them, it’s the difference in how income is calculated and whether your commission or bonus can be used to pay the bills each and every month, and on time. Nonseasonal commissions are calculated the very same way as seasonal commissions, using a two-year plus year-to-date average.
3.12 HOW DO I CALCULATE MY PAY IF I HAVE BOTH A SALARY AND A BONUS OR A COMMISSION?
Some jobs have a base salary plus commission. Or a base salary plus a bonus. In both cases, the lender will begin by adding your commission average to your base pay. If you don’t have a two-year history of commissions, then don’t expect the lender to use them. Or if you got a bonus last year but not this year, then the lender won’t assume any future bonuses.
There is another threshold for those with salary-plus-commission jobs. Lenders don’t consider you a “commissioned” employee if your gross commissions make up no more than 25 percent of your earnings. That is important when it comes to documenting your income.
3.13 IF I CAN DEDUCT A LOT OF EXPENSES FROM MY INCOME TAXES, DOES THAT HELP GROSS MONTHLY INCOME?
Good question. And a common error. Some sales jobs require you to pay certain expenses out of your own pocket. Car payments, gasoline, and automobile maintenance are common expenses, as are taking a business prospect to lunch or taking a client to a football game. Such nonreimbursable expenses, while possibly a tax benefit come tax time, can hurt your gross monthly income. How’s that?
Let’s say that last month you made $8,000 in commissions. If you had no other expenses, that’s the base income your lender will use. However, if you spent $500 for a company vehicle and another $1,000 for business lunches and entertainment, then the lender will deduct those expenses from your gross income. Why? Yes, you made $8,000, but you also claim you had to spend $1,500 to do so. The expenses must be netted from your gross income.
3.14 HOW DO I SHOW EXPENSES ON MY LOAN APPLICATION?
You don’t. You show them on your tax returns. It’s meaningless to write in any expense amount on a loan application because, for one thing, there’s no space for it, and for another, your expenses will fluctuate from month to month.
Some lenders may ask for a year-to-date profit and loss statement prepared by your accountant. This shows gross income less expenses, but all lenders can get expense information from your tax returns. Specifically, federal tax Form 2106. Those who deduct nonreimbursed employee business expenses for income tax reporting use Form 2106. It is here that you deduct your actual expenses from your income, not on your application.
3.15 HOW DO I CALCULATE MY DIVIDEND AND INTEREST INCOME?
Your lender needs to determine if the asset has been around for a couple of years by looking at your tax returns. The lender will then add the two years of interest and dividend income and divide by 24, to get a monthly amount. If you have regular investment dividends that you receive on an annual basis, the lender will review the two most recent tax returns to verify whether the dividend income is consistent.
If you got a $50,000 dividend last year but none the year before, it’s unlikely the lender will use it for purposes of determining gross monthly income. For interest income, it’s the same question: Is it regular and is it likely to continue? Lenders feel such income is likely to continue if they can project that the asset will still be producing dividends for another three years.
3.15A WHAT IS THE 4506-T AND WHY DO I HAVE TO SIGN IT?
The 4506-T is the number assigned to the IRS form that authorizes a lender to retrieve previous years’ income tax transcripts. Lenders do this to compare what is on the loan application with what is reported to the IRS. When there is a discrepancy, usually it’s simply an insignificant amount but if the tax transcripts don’t match, there will need to be some documentation explaining the difference.
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The 4506-T form used to only be required for self-employed borrowers but in recent years lenders use the form with most mortgage applications, regardless of the source of income. The process of requesting and obtaining the transcripts from the IRS has been streamlined and what used to take weeks can now take just a couple of days using a third-party tax retrieval service. Otherwise, delays of up to six weeks or more can occur when the request is made directly to the IRS.
On the form, the lender will list which years are being requested. You will see on this form where these years are listed but if the years aren’t specified, the form would allow the lender to request as many years as it wants. If the years aren’t pointed out, enter the previous two years on your own before signing and returning to the lender.
3.16 HOW DO I CALCULATE MY INCOME IF I OWN MY OWN BUSINESS?
For starters, it’s similar to how someone calculates commissioned income when it comes to gross income and expenses. Take your gross income and deduct your expenses, then average for two years. Certain business types that depreciate or deplete any assets shown on the tax returns may have depreciation “added back” into their income for qualification purposes.
For example, certain tax rules allow for businesses to buy office equipment and then depreciate its value either one time or take the depreciation over a few years. Let’s say a shoe shop owner paid $50,000 for a new shoe repair machine. That tax year, the owner deducted $10,000 for depreciation, which reduced his income by that same amount. But depreciation isn’t a “cash item,” like writing checks for supplies or services. It’s merely a tax deduction. Lenders know this and allow for depreciation to be “added back” to the shoe shop owner’s income when calculating ratios.
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Lenders consider you self-employed if you own more than 25 percent of a business. Own 20 percent of a business? You’re not self-employed. Own 30 percent? You’re self-employed. The first consideration is how your business is structured.
How your business is structured can also affect how your income is calculated. The three basic business structures are sole proprietor, corporation, and partnership.
Sole Proprietor
A sole proprietor is just that: a person who alone owns his own company. You don’t split the proceeds with anyone else; it’s all yours. When you file your income tax returns, you file them as an individual and your business income is entered on page one of Schedule C, the form you use to determine taxable income. Taxable income is your gross income minus your expenses, or your net income.
Let’s say that you own a car wash and it does fairly well. Every month those quarters really do add up and you gross nearly $7,500 per month. Don’t make the mistake of using this amount as your income for purposes of qualifying. Yes, it’s income, but there are also expenses you need to deduct. You buy car wash soap (lots of it), you pay for insurance and maintenance, and you have a hefty water bill. You also pay for some on-site help to manage the car wash and keep it clean. After you pay your help and your bills, you may only have $3,000 left over. This $3,000 is the amount lenders will use to approve your loan.
Corporation
If your company is a corporation, you have one set of tax returns for yourself and another for your corporation. For review, your lender might ask for both sets of returns and all schedules. What would a lender look for? For one thing, to see whether your company is making any money. Heavy losses for the previous two years will make a lender look extra hard at your application. However, if you have a strong credit profile with high scores and low ratios, your lender may ask for nothing more than the first two pages of your personal tax returns and leave everything else alone.
Partnership
A partnership means you’re in business with one or more other people and you split all the net income based upon your percentage of ownership. If you own 30 percent of a partnership and the partnership makes $100,000 after expenses, you’ll get 30 percent of $100,000, or $30,000. A lender may also ask for partnership tax returns, but again that may depend on the relative strength of your loan file.
3.17 HOW DO LENDERS DETERMINE WHETHER MY BUSINESS INCOME WILL HAVE A LIKELIHOOD OF CONTINUANCE?
Well, the lender doesn’t have a crystal ball, but the process is very much similar to someone who receives commission or bonus income. First and foremost, the income must have at least a two-year history. This history is documented with filed and signed federal income tax forms from the previous two years. This also means the borrower must have been self-employed for at least two years. This is often documented with a business license, but most lenders will accept the two years of returns.
The lender will then add the net business income from the past two years and divide by 24 (months) to arrive at a monthly amount used for qualifying. The lender wants to see consistent, year-over-year numbers, not wild swings.
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For example, say an electrician decides to go out on her own and has been in business for nearly five years. Her income after expenses last year was $78,000 while the income from the year before was $65,000. The lender adds the two together, then divides by 24 and arrives at $5,958 per month. The lender also sees that the year-over-year income is increasing and the numbers are relatively constant.
On the other hand, should the years be reversed, the lender might consider the income to be declining and may wonder if there is a problem with the business. That’s a decrease that might concern an underwriter and will likely pose a few questions, primarily, “Why the decline in income?” A proper response would be to explain the dip and that it’s not likely to continue. If there were such a question, an underwriter might ask to go back another year to look at income from three years ago to establish a pattern. If the income from three years ago is relatively consistent with the second year and not the income from last year, the underwriter will likely feel comfortable the dip was in fact a one-time-only event.
Lenders use this consistency to establish the likelihood that the income will continue into the future, most often conjecturing whether similar income will be found three years from now. Because they can only surmise, using recent years’ returns fulfills this guideline.
There are lenders who waive this two-year requirement and use only the most recent year if the individual is considered by the lender as a licensed professional such as a doctor, dentist, or lawyer. This option is completely up to the individual lender.