Income Calculations Explained

While basic understanding of the "book smarts" within the mortgage industry will help you understand specific terminology, loan programs, and features, there is so much more you will need to know in order to make an informed financial decision.

My approach to providing education strives to further your understanding beyond the "book smarts" of the mortgage industry, and learn the valuable "street smarts" that will help you achieve the best possible results, while avoiding the most common pitfalls that non-informed Borrowers and Real Estate Professionals have experienced.

The Mortgage Street Smarts of how your income is calcuated on a Loan Application:

Have you ever stopped and thought about how many different ways a Consumer can earn income?  Below are most of the methods, sources, and structures of income, and how a Lender will calculate them. NOTE: Underwriting Guidelines are constantly evolving, and often vary between Lenders.

Common Misconceptions:

**1099/Independent Contractors are not Self-Employed
**Corporation Owners who have paystubs/W2's do not need tax returns
**Overtime can be used to qualify if paystubs and W2's are provided (NOTE: a 2 year history is required to use this income!)
**Commissioned Employees do not need to provide Federal Tax Returns
**Job Gaps are fine and do not need to be explained or disclosed
**Changing Industries is not an issue
**Extended leave-of-absence does not require an explanation

Definitions:

VOE - Verification of Employment (a 1 page form that is typically sent to the Human Resources Department of the company where the Borrower works)

1040 - Federal Tax Returns (which are form 1040 of the IRS Tax Returns)

4506 - Request for Tax Transcripts Form (allows the Lender to cross-reference the tax returns you gave them for loan approval against the tax returns you gave to the IRS when you filed taxes...do not even think about giving a different set of numbers to Uncle Sam and the Lender...they will catch you!)

YTD - Year-to-Date (a running tally of how much the Borrower has earned since January 1st of a given year)

Employment Types 

Self Employed Borrowers - There are 4 Types

1) Sole Proprietor
**Reports income/loss on Schedule C of Federal Tax Returns (1040's)
**Includes 1099 income as well
**Are not paid by W2
**Borrower has full liability

2) Partnership
**Reports income/loss on both Personal & Business Tax Returns
**Has Schedule K1 which shows percentage of business owned
**Uses Form 1065 of Partnership Tax Return (1065's show overall performance of business)

3) S-Corporation
**Reports income/loss on both Personal & Business Tax Returns
**Can receive W2
**Has Schedule K1 which shows percentage of business owned\
**Uses 1120's for the S-Corp Tax Returns (1120's will show overall performance of the business)

4) Corporation
**Reports income/loss through Business Tax Returns ONLY
**Receives W2
**Uses 1120 for Corporation Tax Returns

How the Income is Calculated

**W2's - (Gross Pay = Largest number of boxes 1, 3, or 5)

**Schedule A (2106 Expenses are shown on Line 21) - These are non-reimbursed expenses the Taxpayer is "writing off."  This income is deducted from total earnings when qualifying for a mortgage.

**Schedule B (Dividends/Interest) - Add Lines 4 & 6 (only used if same assets will be available for 3 years after close of new loan, and consistent for past 2 years historically)

**Schedule C (Sole Proprietor Profit & Loss) - This form frustrates most Borrowers and Real Estate Agents!  Lenders look at the income you NET (not what you GROSS).  To calculate, take Line 31 and "add back" Lines 12, 13, & 30.  Typically the last 2 years of Schedule C's will be examined this way, with the total amount of both years then divided by 24 months (to determine monthly income)

**Schedule D (Capital Gains/Losses) - Line 21 (if positive number, then add to income...if negative number, subtract from income)

**Schedule E (Rental Property Analysis) - Take Line 3 (total rents received) and subtract Line 19 (total expenses).  This is another form that hurts Borrowers when they apply for a loan.  

**Schedule E (Partnership / S-Corp Returns) - Take Line 32 (if positive number, then add to income...if negative number, subtract from income)
 
Business Tax Returns

**Corporate Tax Return (Form 1120) - Take Line 20 + Line 21, then add/subtract Line 30 (Taxable Income/Loss), subtract Line 31 (Total Tax), then subtract L-Line 17d (Mortgage, Notes, Bonds Payable in LESS than 1 year) multiply by Ownership Percentage (noted on Schedule E of 1120)

**S-Corporation Tax Return (Form 1120) - Add Lines 14 + 15, subtract L-Line 17d (Mortgage, Notes, Bonds Payable in LESS than 1 year), multiply by Ownership Percentage (noted on K1, Line F)

**Partnership Tax Return (Form 1065) - Add Line 16a + Line 17, subtract Schedule L-line 16d (Mortgage, Notes, Bonds Payable in LESS than 1 year), multiply by Ownership Percentage (noted on K1, Line J), add Guaranteed Payments (K1, Line 14)

Hourly Employees

Hourly Income (40 Hours Per Week) - Paid hourly (if the Borrower works 40 hours per week)
** Hourly wage x 40 (hours per week) x 52 (weeks per year) divided by 12 (months) = Monthly Wage

Hourly - Hours Vary
**Previous year W2 + YTD earnings, divided by the appropriate number of months = Monthly Wage

Salary Employees - Can be paid in several ways (listed below)

**Bi-Monthly (paid twice per month, typically on 15th and last day of month).  Take the amount received each pay period and multiply that by 24 pay periods, then divide by 12 to calculate monthly income.

**Bi-Weekly (paid every 2 weeks for a total of 26 pay periods annually).  Take the amount received each pay period and multiply by 26 pay perids, then divide by 12 to calculate monthly income.

**Monthly (easy to calculate...paid once per month). Simply use the amount received each pay period as monthly wage.

Commissioned Employees - Can be either 100% commission or receive a base salary + commission. 

Borrower will need a 2 year history of receiving commissions to be considered stable (otherwise this income is not counted).  Commissioned Employees tend to write off unreimbursed Employee business expenses on their tax returns (2106 expenses from Schedule A on the 1040's).
**Take the amount of base (if any) + a 24 month average of commissions minus 24 month average of 2106 expenses.

Fixed Income

**Social Security (not received until age 62...if received prior to age 62, then it is not retirement income and proof of 3 year continuance is required). Non-Taxable Social Security income may be "grossed up" to 125%.  To calculate, take monthly income and multiply by 1.25 to determine income.

**Long Term Disability (Income usually comes in the form of a monthly payment from Social Security Administration or from an Insurance Company).  This can be received at any age, however proof of 3 years continuance is required.  Any Non-Taxable portion may be "grossed up" by 125% (except for VA loans)

**Temporary Disability (Income may be used to qualify, but additional requirements will apply). A defined date of release to return to work must be provided along with proof the Borrower will return to same job & same pay.  The lesser of the base pay or temporary disability would be used to qualify. This is not easy to prove, but is accepted on a case-by-case basis (i.e. maternity leave)

**Pension Income - Income comes in the form of a monthly payment from Employer/Union in which the Borrower retired.  Government, Military, and Large Companies are common distributors of Pension Income. Generally they do not require proof of continuance and are considered stable.  This income is taxed already and therefore would not be "grossed up" by any amount.

**Retirement / Annuity Income - This income may come from 401K, IRA, or other Investment Accounts.  The income must be consistent to use for qualifying purposes.  A 2 year history of drawing money from the accounts is required.  The accounts must have enough money to provide the same level of distributions for 3 years after close of escrow on the new mortgage loan.

Other Sources of Income:

**Military Employees - The base pay is taxed but other pay is not taxed (BAH & BAS allowances may be "grossed up" by 125%)

**Postal Workers - Postal Worker paystubs do not have pay period dates (which make it difficult to determine income from the paystub). There is a published Postal Worker Pay Date Chart to assist in calculating income)

**Employed by a Relative - Tax Returns for Borrower will always be required in addition to paystubs, and W2 form.  A 4506 Form will always be executed to cross-reference income reported to IRS.

**Handwritten Paystubs, W2's or Tax Returns (these are NEVER acceptable).  A full Verification of Employment (VOE) must be ordered in addition to a form 4506.

**Foster Care Income - Child or Adult Foster Care income may be used as long a sufficient proof is provided.  12 months proof of receipt and a letter from the Foster Care Agency showing the income will continue for 3 years will be necessary.

**Trust Fund Income - A copy of the Trust must be provided.  The Federal Tax Returns will also be required.  It must be proven that the remaining funds in the Trust are enough to provide the same level of income for an additional 3 years.

**Auto Allowance - Need to prove it has been received for 2 years and the Company must state it will continue.  This may be used as an offset to auto payment but not as income.

**Child Support - Support Order or Divorce Decree is required.  Document the age of children to evidence the income will continue for at least 3 more years.  Income for children in college may NOT be used.

**Alimony - The Divorce Decree or Marital Settlement Agreement is required.  The terms must be disclosed, and evidence 3+ more years of continuance.

**Rental Income - Federal Tax Returns will be required (Schedule E, Line 3 minus Line 19 = Rental Income). In rare cases, the current Lease Agreement may be used.

**Boarder Income - Room Rent or Boarder Income is generally unacceptable.  The exception to the rule is FHA will accept this income if it appears on the last 2 years Federal Tax Returns as Rental Income.

Paystub Deductions (hidden pitfalls that will hurt the overall income used) include garnishments for: child support, spousal support, liens, judgments, and any other court ordered garnishment.

For more information on topics like this, please feel free to visit www.MortgageStreetSmarts.com (an educational resource for Borrowers, Real Estate Agents, and Financial Professionals)

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