- Wage Earner
- Self-Employed Income
- Debt to Income Ratio
- Commission Income
- The Four Cs
- The Four Cs: Cash
Typically, a wage earner needs two years of history to show that he has a stable income. If there is a good reason to show why there aren’t two years of history – like when they’re in college or had a baby so had to take a few months off – they need to show documentation as evidence. Afterward, they can be approved based on their income.
There are two types of wage earners: those who get paid hourly or a salary.
For salary workers, banks will need your current income or when you got a raise. They will look at your current income and base calculations on that as long as your history shows a stable income.
For hourly employees, the bank will send verification of employment to your employer. The employer will fill out information showing how many hours you averaged over the week and how much you got paid. The bank will take your current pay rate multiplied by the number of hours you averaged. So it’s the average of last year multiplied by the current rate.
The bottom line: Banks will want to see your two-year history. It’s your current rate versus average hours. That’s what they’re going to calculate.
There are many ways you can have your self-employed income. You can have it from rental properties, from a business where you are a partner, and others.
Generally, the bank will require two years of tax returns because they’re going to average out the income over the two years. Unless you’re self-employed for five years, in which case it shows that your business is stable and the bank will base it on just a year of tax returns.
There are instances where the bank gives an exception to those self-employed for less than five years and base it on a year’s tax returns. But that takes some expertise on the loan officer side. We actually get a lot of deals like this. A few times borrowers were denied because their two-year tax history wasn’t enough, but the one year was. So when you have the expertise and a team that helps out, you learn the tricks about getting approved on one year’s taxes.
A self-employed income generally needs two years. The calculations aren’t just based on taxable income. Many people just throw numbers like gross profits before deducting anything and others go by their taxable income. It’s important to know that the taxable income and the income used by the bank are two different things.
The bank will look at your cash flow, or how much money is consistently coming through your business that’s your money. They will look at the money after you take away all your expenses.
But there is also depreciation which is a tax benefit. It’s a deduction and not an expense. Something like home office expenses can be added back to your income. Or let’s say someone has a one-time expense in his business like a restaurant owner who bought an oven for $20000, or a construction company who got a truck for a few thousand dollars. That would need a letter from the CPA saying this is a one-time expense and the owner doesn’t need to buy another like it again every year. Then that money can be added back to your income.
Someone told me he needed a refinance but didn’t have enough income. When we analyzed his tax returns, we saw he had a depreciation of thousands of dollars. He was making money but he was able to deduct it from his taxes.
The bottom line: When calculating self-employment income, it’s important to have it done through a loans officer. But remember that your taxable income is not your gross income. It’s your income after expenses. And any deduction or one-time expense can be added back to your income.
Gifts for a purchase of a primary residence are allowed. On a single-family house, you can have an entire downpayment come as a gift. You don’t have to spend a dollar from your own pocket. You can get it as a gift.
A gift has to come from a relative. It can be from your parents, an uncle, your cousin – anyone who is a relative.
When you get a gift, the banks will want to see that the money came from a donor. Cash wouldn’t be a good source because it is unverifiable. So they’d want to see it came from the donor’s account into your account with a letter saying it’s a gift that doesn’t have to be paid back and with no obligations.
On a conventional loan, the bank will not verify where the donor got the money. But they will on FHA loans because they want to make sure that the donor has the ability to give such gifts.
When applying for a mortgage, one of the most important things to take into consideration would be how much the bank will approve you for. The bank uses a calculation of the debt to income ratio. They will basically assess your monthly obligations versus your monthly income.
Whatever your monthly income is as a wage earner, they’ll see what percentage of it falls under your monthly obligations. These are the things that show up on your credit report. They could be broken down into four categories:
the mortgage you’re applying for (including taxes and insurance, HOA, and others associated with the purchase)
car payments (lease or finance)
minimum payments on your credit card (not to be confused with your credit card balance)
any loans you have on your personal name (student loans, property loans, child support, etc.)
Ideally, the banks would want your debt to income ratio to be 45%. That means your monthly obligation should be 45% of your income. If you have good credit on file, it could even go up to 50%.
Generally, most people buying a primary residence have decent credit and can make calculations based on their monthly obligations being a bit less than half of the monthly income.
Here’s an example: you’re buying a house and your monthly payments are $2500 a month including taxes, insurance, and other fees. Then your car payments are $350, and your credit card with all the minimum payments are $150. That’s $3000 rounded off. So your monthly income has to be at least double that.
With a ratio of 49.9%, you would have to make a little bit over $6000 to qualify for a house with a $2500 a month payment.
For a commission income, the bank will take the average of the last two years of income. It needs to be a full two years.
There are instances when they could go for 12 months if they see positive factors. But usually, they’ll use the average of 24 months as your income.
And as a loan officer, they’re one of the hardest people to get approved for a loan mortgage.
There are four things that the bank will look at when they assess a borrower. They are known as the Four Cs: capacity, credit, collateral, and cash.
Capacity is the ability to pay back a loan in whatever amount. Based on your income and monthly liabilities, they will determine how much they’ll lend you.
Credit score and credit report will be analyzed if it’s good and you don’t have any foreclosures, things like that.
Collateral is when they’re going to lend based on the house. How much is the bank going to lend you? Let’s say you want to borrow $500,000 and the house is $600,000. How will the bank know that if you default on the loan, they can sell it for $600,000? They will send a third-party appraiser to assess the house so they can use that to evaluate how much the house is worth.
Then there’s cash. You’ll need money for a downpayment and closing costs. The bank will want to see where the money comes from: is it a loan, illegal, or clean? They would want to verify that.
When you’re buying a house, you’re coming in with tens of thousands or even hundreds of thousands of dollars to the deal. What type of money is acceptable?
There are many laws that banks have to adhere to to make sure it’s not illegal money or drug money or laundered money. Or for their own good, they’ll want to make sure you didn’t borrow the money and have some debt they don’t know about. They don’t want to learn that after you close the deal on the house.
The bank will look at your liabilities versus your monthly income so everything has to be disclosed. They will ask you for two months of bank statements. They’d want to see if you’re coming into the transaction for, say, $100,000 including closing costs and the downpayment. Your most recent two months of bank statements should show that the money was in your account. This means it’s safe to assume that it’s good money, not borrowed or illegal.
If you had any large deposits like something more than half your monthly income based on the calculations made by the bank to qualify you, they’ll ask you where the money came from. You’re going to have to show them where it came from, otherwise, they will disqualify that money from being used in the transaction.
The bottom line: The bank will ask you for two months of bank statements which they’ll analyze for transactions into the account, and any deposit of more than half your monthly income will be questioned so you have to show them documentation (which has to be a good reason and a good source).