Credit Scores

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Debt to income Ratios

There are two ratios that a lender will be interested in; 1) your housing ratio, also known as your “front end ratio,” and 2) your debt-to-income ratio, also known as your “back end ratio.”

The housing ratio is your gross monthly income (your income before taxes are deducted) divided by your total housing payment. Your total housing payment includes principal, interest, taxes and insurance.

Your debt-to-income ratio is calculated the same as the housing ratio, except all revolving and installment debt is added to the housing payment and divided by your gross monthly income.  Revolving and instalment debt can include credit cards, student loans, car loans, personal loans, etc.

Ideally, these ratios should be less than 35% for the housing ratio, and less than 45% fpr the debt-to-income ratio, although today many loans are approved with a borrower having a ratio as high as 55%.

Can I use all of my income?

There are very specific guidelines that must be followed in determining what income is allowable in qualifying for a home loan. For example there are a few situations that prevent you from utilizing your income.

The first is if you have been self-employed for less than two years. Generally speaking you must be able to document that your business has been established for at least two years and have a minimum of one full years’ tax return before you are able to use this income. This also includes people who are paid 1099 income (no income taxes deducted by your employer).

Other situations that potentially fall under the two-year rule are individuals who have commission pay or bonus pay as the basis for their income.  If you have changed jobs and are in the same line of work with similar payment arrangements, sometimes underwriters will make exceptions.

For example: You are currently paid a straight base salary. You get an offer to go to work for XYZ Company, taking a 20% cut in base salary in exchange for commissions that historically for that position would give you a 25% to 30% raise effectively. The problem is that without any history of you receiving commission income, the lender will not allow any consideration for it and worse yet, qualify you off the smaller base salary which is 20% less than your old job.

My Monthly Bills

Monthly obligations that are counted against you when qualifying for a home loan include credit cards, student loans, (even if deferred), auto loans, personal demand loans, and any other revolving, or installment loans. For credit cards, the lender will count your “minimum monthly payment” when qualifying you for a loan.

Items that do not count against you are insurance, (medical, auto, life) utilities and other personal expenses. In addition, installment loans with fewer than 10 payments remaining can be excluded for qualification purposes.

Assets – How much have you saved?

This is an area that requires some care and education. Lenders will be looking to verify that you have in the bank the necessary funds to close the loan (cash needed at closing) and anywhere from one to two months reserves, depending on your credit and the individual program guidelines. Reserves are your estimated monthly housing payment.

Most conventional lenders require that any money being used for the purchase of a home be “seasoned” for at least one month. In other words, the money must have been present in the account for a minimum of 30 days. Large deposits into your account must be explained to an underwriter. If for instance, you sell a car for $4000 and deposit the money in your bank account. You will now be asked to provide documentation as to the source of this money, including a bill of sale and/or a copy of the check and deposit slip. In the event that someone pays you for this car in cash, there is no way to show a “paper trail” to the underwriter, and the money will not be allowed to be used towards the purchase of your home!

There are also very stringent requirements on gifts from relatives, such as how much you can receive and how to document the gifts.

The best advice is to talk with a mortgage professional well in advance of getting started to gain a clear direction on where to “stash” your money and how to document large deposits, gifts, and transfers between various accounts.

Last but not least, retirement accounts are reduced by 30% of the “vested balance” for qualifying purposes. These accounts can be used for the “reserves” mentioned earlier in this section.

Employment History

This is a big factor in qualifying for a mortgage. Generally speaking, the lender will want to see your last 2 year history. The big issue here is how you are paid. If you are on a straight hourly wage or salary and paid as W-2 employee, it is fairly straight forward. You will qualify off that income. If you have changed jobs recently, this is typically not a problem.If you are paid a base salary plus bonus and/or commission it gets trickier. You must have a two year history of receiving bonus and or commission before you will be allowed to count it as income. Same goes for those that are paid 100% commission; you must be able to provide 2 years of tax returns showing the receipt of such income.

If you are paid as a contract employee, 1099 income or are self employed, you have the same requirement. You must be able to prove 2 years of history before you will qualify. The lender will be looking for copies of business licenses or your CPA to write a letter saying that you have been self employed for the last 2 years. The income they will use to qualify you is the net income you report to the IRS after your deductions.

If you do not have a 2 year history yet, there are other solutions that may work. Talk to a mortgage professional and see what other options may be available.