3 Fatal Income Calculation Mistakes (and how to avoid them)
I am in a unique position as lender. Because I have been educating and empowering homebuyers and homeowners on this website since 2007, I have carved out a unique space where most of my business comes as the result of something going wrong.
We get over 20,000 visiting this website every month. As you can probably imagine, most people only google questions after something unexpected or questionable happens, especially when it comes to qualifying for a home loan.
The good news is, our efforts to help people make informed decisions has provided many folks a second chance, or at least a second opinion, and in most cases, we’re able to help save loans, and buy homes.
Unfortunately, we can’t save them all. What never ceases to amaze me are the simple mistakes that lenders make that inevitably will result in those ticking time bombs blowing up at the most inconvenient times.
Actually, before I dive into this, let me preface this by saying that I don’t think that most lenders do not do a good job. While there are some people that I think are lazy, and don’t spend enough time analyzing your documentation, I think that the majority of pre-approval challenges are caused by oversight, or guidelines changing so quickly that loan officers have challenges keeping up to date.
Let’s look at the most common income calculation challenges, why they happen, then we’ll talk about ways to avoid these mistakes, and set yourself up for a better home buying experience.
Fatal Income Calculation Mistakes
Calculating income is getting trickier as more and more people are working multiple jobs and overtime, sometimes specifically to help save money to buy a home. It’s also more and more common for people to change jobs more often.
When you combine multiple income streams, with multiple jobs, you increase the risk of an inexperienced loan officer making a fatal mistake when calculating your qualifying income.
Bonus, Commissions, and Overtime
One really common mistake that I see made is a failure to dig into income, and make sure that certain income streams can be used. Because these income streams can be variable in nature, they are not calculated the same way as your salary, or hourly pay.
There are two things that an underwriter will look at to determine how to calculate this income.
- Have you been paid by this method for 2 years?
- Is the income stream steady, increasing, or decreasing?
If your variable income is steady or increasing on your current YTD pay stub, it will be averaged over the previous 2 years, including YTD. When the lender orders a Verification of Employment, we need your employer to break out your variable income. We will take 2014, 2015 and YTD, and divide it the calculated months. This average is used as your variable income calculation.
If the variable income stream is decreasing, it’s possible that the underwriter will not feel comfortable using it at all when calculating your income. This can sometimes be overcome with a good explanation for the decrease, as long as you can show that it was a one time or temporary occurrence that caused the dip.
Tax Returns vs W2 Income Verification
For the past 7 or 8 years, lender have been requiring that we use full tax returns, including all schedules, to calculate your income. We also have to order tax transcripts from the IRS to verify that the amounts on the tax returns are accurate. This is done by having you sign a 4506T authorization form.
For most borrowers, this isn’t a big deal. For borrowers that have a creative tax person, there may a 2106 form, which allows you to write off unreimbursed employee expenses. This is commonly used if you are required to purchase uniforms, or supplies for your job that your employer does not pay for, or reimburse you for.
If an underwriter sees a form 2016, this “write off” is averaged over the previous 2 years, and deducted from your qualifying income. There are some types of 2106 expenses that can be ignored if they are one-time, or non-typical expenses. Most lenders have a 2106 calculator that will help to identify the opportunity to reduce this deduction for qualifying purposes.
More recently, most lenders are now allowing W2 only verification of income. The ability to verify your income using W2 only completely avoids the need to consider 2106 expenses.
Below is an excerpt directly from Fannie Mae that describes the circumstances by which Federal Income Taxes are required:
When does Fannie Mae require federal income tax returns to document income?
Fannie Mae requires that federal income tax returns be provided when one or more of the following income sources are being used to qualify:
- Commission earnings that amount to 25% or more of the borrower’s total employment income;
- Employment by family member(s) or an interested party to the purchase transaction;
- Rental income from an investment property (if acquired prior to the most recent tax filing);
- Income from temporary or sporadic employment (for example, seasonal income);
- Income reported on IRS Form 1099 (for example, capital gains, royalties);
- Income earned from a foreign corporation or foreign government and paid in foreign currency;
- Income earned that cannot otherwise be verified by an independent and knowledgeable source;
- Income from interest and dividends;
- Income from self-employment (defined as a 25% or more ownership in the business);
- Income reported to the borrower on schedule K-1 (regardless of percentage of ownership).
In these cases, the tax returns provide the underwriter with a more comprehensive view of the borrower’s income, and enable identification of any related expenses that may need to be factored into the income calculation.
Part Time and Second Job Income
Many people have part time, or second jobs to help make ends meet, or to supercharge your savings. Part time employment and second job income can only be used if you have a 2 year history of working part time, or a second full time job.
If you do have a 2 year history of this type of income stream, it is calculated similar to other variable income streams and will be averaged over the past 2 years, including your YTD income. This type of income calculation also will take into consideration consistency of income, and whether or not it is steady, increasing or decreasing.
Decreasing income from a second job or part time employment may not be able to be considered in your qualifying income calculation if it seems like this income is going to continue to decrease.
How to Avoid Fatal Income Calculation Mistakes
If you’re already a homeowner, these mistakes are not as fatal, you already own the home, and the worse case scenario is that you maintain the status quo. Maybe you are unable to take cash out, or you miss out on an opportunity to reduce your rate, payments or the term of your loan. It could be worse.
As a homebuyer, one of these fatal mistakes could cost you appraisal and inspection fees, and in extreme cases, you could lose your good faith deposit. It doesn’t get much worse than that.
If your loan officer does not know these guidelines, or overlooks an employment timeline, or income pattern, you could be doomed before you even start. Once your documentation is sent to the underwriter, the cannot “un-see” the documentation provided (in the case of submitting tax returns instead of W2s).
If you are working with a direct lender, and your file is pre-qualified incorrectly, you’re done. If you are working with a broker, it’s possible that they still have the opportunity to correct their mistake, and submit your file to a new lenders for consideration.
The single best protection against qualifying income calculation mistakes is to have your loan underwritten BEFORE you start making offers on homes. Many lenders are now offering to conditionally underwrite your loan package prior to you finding a home to buy.
By having an underwriter review your income, assets and credit, you will have a huge head start once your offer is accepted. You will not only be able to avoid expensive surprises, you also have the opportunity to speed up the escrow process and close on your home sooner.
In a competitive market where there are few homes on the market for sale, and many buyers looking for homes, being able to close quickly is a very big competitive advantage.
I would not say that you must absolutely always insist on a conditional underwriting approval, but in situations where you have any concern at all about variable or inconsistent income or employment, I think it’s crazy to not take extra precautions so that you can rest a little easier once your offer is accepted.