Mortgage Underwriting in The United States - Income Analysis

Income Analysis

Capacity refers to the borrower’s ability to make the payments on the loan. To determine this, the underwriter will analyze the borrower’s employment, income, their current debt and their assets.

While reviewing the borrower’s employment, the underwriter must determine the stability of the income. People who are employed by a company and earn hourly wages pose the lowest risk. Self-employed borrowers pose the highest risk, since they are typically responsible for the debt and well-being of the business in addition to their personal responsibilities. Commission income also carries similar risks in the stability of income because if for any reason the borrower fails to produce business, it directly influences the amount of income produced. Usually if self-employment or commission income is used to qualify for the mortgage, a two year history of receiving that income is required.

Documentation of the income also varies depending on the type of income. Hourly wage earners who have the lowest risks usually need to supply paystubs and W-2 statements. However, self-employed, commissioned and people who collect rent are required to provide tax returns. Retired people are required to evidence that they are eligible for social security and document the receipt of payments, while people that receive income via cash investments must provide statements and determine the continuance of the income from those payments. In short, the underwriter must determine and document that the income and employment is stable enough to pay the mortgage in years to come.

Furthermore, underwriters evaluate the capacity to pay the loan using a comparative method known as the debt to income ratio. This is calculated by adding up all of the monthly liabilities and obligations (mortgage payments, monthly credit and loan payments, child support, alimony, etc.) and dividing it by the monthly income. For an example, if a borrower has a $500 car payment, $100 in credit and loan payments, pays $500 in child support and wants a mortgage with payments $1,000 per month, her total monthly obligations is $2100. If she makes $5,000 a month, her debt to income ratio is 42%. Typically the ratio must be below anywhere from 32% for the most conservative loans to 65% for the most aggressive loans.

Assets are also considered when evaluating capacity. Borrowers who have an abundance of liquid assets at the time of closing statistically have lower rates of default on their mortgage. This is termed as reserves by the industry. For example, with a total mortgage payment that is $1000 a month and the borrower has $3000 left after paying the down-payment and closing costs, the borrower has 3 months reserves. Underwriters also look closely at bank statements for incidences of NSF's (non- sufficient funds). If this happens regularly, this is a red flag with the underwriter because this indicates that the borrower doesn't know how to manage his or her finances.

Furthermore, if the borrower’s employment is interrupted for any reason, the borrowers would have enough cash in reserve to pay their mortgage. The amount of cash reserves is qualified by the number of payments the borrower can make on their total housing expenditure (the total of the principal and interest payment, taxes, insurance, homeowners insurance, mortgage insurance, and any other applicable charges) before the reserves are completely exhausted. Often lenders will require anywhere from two to twelve months of payments in reserve. If a borrower is applying for an FHA (Federal Housing Administration), there are no reserves required however, it makes the file that much stronger if you have at least 2 months reserves.

The most typical asset is a borrower’s checking and savings account. Other sources include retirement funds (401K, Individual Retirement Account), investments (stocks, mutual funds, CDs) and any other liquid source of funds. Funds that have penalties for withdrawing must be considered conservatively and are evaluated at 70% or less of their value. Accounts such as pensions and other accounts and personal property that lack liquidity may not be used as assets.