Everyone has heard that mortgage underwriting has gotten tougher and that, as a result, it’s harder and harder to qualify for a mortgage and to get through the mortgage process. Today, lenders scrutinize every detail of a borrower’s loan application and if you are not prepared for this extra scrutiny the experience can be frustrating and the result can sometimes be a decline.
If you are thinking about buying or refinancing a home, there are 5 things you need to know to get through the process successfully, qualify for that loan, and save yourself some frustration along the way. In this post, and in the next 4 posts, we’ll discuss these 5 things – 1) Income, 2) Assets, 3) Credit, 4) Earnest Money, and 5) Interest Rate Lock.
Let’s start with income.
1. Be Prepared to Document & Verify Your Income & Employment: Income used to qualify for a mortgage needs to be documented to the lender’s satisfaction and generally has to have an expectation of lasting at least the next three (3) years. Lenders generally go back for at least two (2) years to document income. If you are paid a salary or earn an hourly or weekly rate of pay, your documentation is fairly simple. All you’ll need is the past 2 years of W2 forms and the most recent 30 days of pay stubs. Likewise, if your income is from pensions, retirement plan payments, and/or Social Security than you would just need to provide the most current award letter for the pension and/or 1099R for the retirement income.
If you are self-employed (meaning you own more than 20% of a business) then your situation is a bit more complicated. You’ll need to provide the past 2 years personal and business tax returns with all W2’s and K1’s, a signed YTD profit and loss statement for the business and a current balance sheet (generally prepared by the business’s CPA or accountant). If you pay yourself a salary from the business, but report a loss on your business tax returns, Schedule C, or K1’s then understand that a lender will look at your net income from the business when calculating income that can be used to qualify for a mortgage. There are certain non-cash expenses, such as depreciation and depletion, that can be added back into income for qualifying purposes.
Income from rental properties can also be used to qualify for a mortgage, but you will need to document the income through leases and/or your tax return. The lender will look at the net rental income from the property using either the actual net income from Schedule E of your federal income tax return or by using 75% of the rental income from the lease. The 25% factor accounts for expenses and vacancy.
In addition, at the time of the mortgage application, you’ll be required to sign an IRS Form 4506T – Request for Transcript of Tax Return which allows a lender to request a transcript of your most recently filed federal income tax returns(s) directly from the IRS. The transcripts direct from the IRS are used to verify and validate the income documentation that your provide the lender with your application.
Here are some helpful hints to make your income documentation process go smoothly:
1. Make sure the 4506T is completed correctly. If you moved and filed last year’s return from a prior address make sure your lender knows that and shows the prior address on the form. Otherwise, the 4506T request will be rejected by the IRS and could cause delays in processing your loan.
2. Make sure your most recent year’s federal income tax return has been filed or that you have documentation of an extension. After April 15th of each year, a lender will want to document the most recent years income tax return or transcript.
3. If you are using interest and dividend income for qualifying, you’ll need two years worth of tax returns and the lender will average the interest/dividend income and you’ll need to provide current statements showing those income earning assets are still available to earn income for you going forward. So, if you are using those assets for your down payment, the lender will not allow you to use the income earned by the assets in the past as qualifying income for the mortgage loan.
4. Be careful if you show loses on Schedule C from a part-time business as this can reduce your salary or other income and affect your qualification for the loan. The same is true if your deduct large unreimbursed employee business expenses.
5. Be prepared to provide all K1’s from investment and real estate partnerships, even if the income from them is negligible. The lender is going to want to see that you do not own more than 20% of the partnership and therefore would be required to provide a partnership tax return.
6. If you income has declined year to year, be prepared to write a letter of explanation to the lender explaining the decline and why it is not an indication that your earnings will continue to decline in coming years.
These are only some of the income situations that can arise during the mortgage qualification process. It is important that you understand how a lender will look at your income and be prepared to document it to the satisfaction of the lender. Your documentation should be complete and any copies should be clear and legible. I hope this information is helpful and please look for Part 2 in this series as we discuss how to document the assets that you’ll need to show for your down payment, closing costs, and reserves.