When reviewing loan applications, mortgage lenders typically look for two main things: borrowers’ likelihood of repaying the loan, which is typically determined by their credit score; and their ability to do so, which is typically determined by proof of income.
The debt-to-income ratio (DTI)
Borrowers must prove their income is sufficient to cover monthly mortgage payments, even if they have impeccable credit. This is determined by calculating their debt-to-income ratio (DTI), which is all their monthly debt payments divided by their gross monthly income. Lenders use this number to measure a borrower’s ability to manage the monthly payments to repay the money they plan to borrow. To calculate a borrower’s DTI, the lender adds up all their monthly debt payments and divides them by their gross monthly income. Gross monthly income is generally the amount of money a borrower earns before taxes and other deductions are taken out. For example, if a borrower pays $1500 a month for their mortgage and another $100 a month for an auto loan and $400 a month for the rest of their debts, their monthly debt payments are $2,000 ($1500 + $100 + $400 = $2,000). If their gross monthly income is $6,000, then their debt-to-income ratio is 33 percent ($2,000 is 33% of $6,000).
The requirements for a borrower’s debt-to-income ratio (DTI) are not set in stone, according to Fannie Mae’s guidelines. There are a number of variables that determine what a borrower’s DTI should be. For example, Fannie Mae requires that a borrower’s DTI can’t exceed 36 percent of their stable monthly income. However, that maximum can go up to 45 percent if the borrower meets credit score and reserve requirements (some lenders require you to have three to six months of cash reserves to cover mortgage payments after you make the down payment).
Fortunately, there’s a range of mortgage loans designed for people with various financial needs, from government-assisted loans to the conventional fixed-rate type. However, there are some basic income documentation standards that borrowers should be aware of before they start shopping for a mortgage. When underwriting conventional mortgage loans, most lenders follow the guidelines of Fannie Mae and Freddie Mac.
Acceptable Income Documentation
Fannie Mae and Freddie Mac have a list of acceptable income documentation, but it’s not exhaustive. If you have a relationship with a bank that knows your history and thinks you’re good for a loan, you might be able to secure a mortgage without meeting every standard requirement.
For FHA loans, there are no specific income requirements. Instead, lenders look at how much income is eaten up by monthly bills and debt service, as well as your employment track record. A borrower’s salary doesn’t play a big role in FHA underwriting, though typically, a lender will assess applicants with higher salaries as less-risky borrowers.
If you’re reporting income from second jobs, you must provide tax documents in support. If you’re self-employed, you usually have to show proper tax documents and complete Fannie Mae’s Cash Flow Analysis or another similar tool as part of your application
For the most part, however, borrowers should have these documents are in order:
If base pay, bonus pay and commission income make up less than 25% of the borrower’s total annual employment income, then a completed Request for Verification of Employment (Form 1005), or a recent pay stub and IRS W-2 forms covering the most recent one-year period are required.
If earned commission makes up more than 25% of the borrower’s total yearly income, then either the 1005 or the borrower’s recent pay stub and IRS W-2 forms, as well as copies of the borrower’s signed federal income tax return are required.
Fannie Mae Acceptable Income Sources
- Base pay (salary or hourly)
- Bonus and overtime
- Commission
- Secondary employment income (if you have more than one employer)
A borrower may also qualify for a mortgage if you they are self-employed or do freelance work and have tax returns showing thier self-employment income for the past year. But some lenders may ask for two years of tax returns to approve a mortgage application.
Fannie Mae accepts more than 20 kinds of non-employment income as well. Borrowers need to provide proof of any income they claim from these sources. Having more income can help a borrower qualify for a mortgage, as long as their credit score and debt-to-income (DTI) ratio are good enough. Some examples of non-employment income are dividends, retirement pay, alimony, child support, income from boarders, royalties, Schedule K-1, foster care pay, trust income and Social Security benefits.
Bottom Line
Income qualification matters a lot it comes to financing a home. It may be more important than a high credit score. Potential homebuyers should think about their DTI long before they buy a home, even if it’s years away. For example, if a future borrower want to buy a car now and a home later, they should calculate their DTI as if they already have a mortgage. That way, they can see how high their monthly car payment can be without putting their DTI over 36%
Talk to a loan officer before you apply for your mortgage. They can help you understand the income requirements for conventional loans, how much income you need for a mortgage and what else you need to do to improve your chances of getting approved.